Loans between family members or friends are extremely common, and although you have saved yourself from the hassle of filing a loan from the bank, you should still treat the situation as strictly business, especially since loans that are unpaid can affect relationships negatively and can even lead to severed ties.
Unpaid debt, especially with family members and friends, can create an awkward and uncomfortable situation that causes a ripple effect and could strain even the strongest of relationships. However, despite its potential negative impact, a lot of people are resorting to informal family loans each year. In fact, research says that informal and unpaid loans that transpire between families and friends lead up to billions of dollars each year.
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Lending money – or anything that has to do with money that is not given freely – should always involve a written contract of agreement. No matter how saintly and godly your intentions may be for allowing a kin to borrow money from you, a loan agreement contract is still essential to protect your interests and to make sure that both parties are in the same page about the terms leading to the loan process. Here are some things that you might want to consider when offering to lend money to friends or families:
1. Set Proper Expectations
The lender and the borrower should be open and honest with each other to make sure that the transaction goes smoothly at any point wherein the loan is still unpaid. One common mistake for loan-making between family and friends is that lenders tend to be afraid or embarrassed to ask how soon the loan will be repaid, while borrowers tend to assume that the money given was a gift instead of a loan. This is understandable, especially since the society that we live in deems public money talks as uncouth. This should not be the case, especially if money talks are related to business or loans. Be sure to always ask. Lenders should confirm with the borrower on how soon it will take for him to repay the money being loaned and borrowers should not be quick to think that the money given was a gift. If you are not sure, ask.
In the commencing part of processing a loan, a borrower should be able to provide the exact amount that he needs to borrow and the reason why he needs the cash, the exact date that he can repay the lender, and the consequences for payment defaults or non-payment (severed ties, disputes, etc.). Lenders should also take into consideration the implications of the loan. If the lender does agree to the loan, will it damage or affect his financial status in the event that the borrower will not be able to pay it back? Lenders should not be forced to shell out money just because they feel that they have to or because they are pressured into doing it. This situation usually ends up negatively with the lender feeling greatly resentful to the borrower and the possibility of a big outbreak if the latter fails to repay the debt.
2. Always Have a Written Agreement
Gone are the days when agreements were settled or finalized with the mere shake of a hand. As pessimistic as it may sound, cheating, lying, and stealing have become such a rampant trait in today’s world that you hardly ever know who to trust. If you want to protect yourself and your interests, then you need to make sure that the person you are lending money to is serious about paying you back, and in this case, more than talk is helpful.
A loan agreement contract will help you clearly and properly lay out the terms of the loan such as the time frame and the interest rate. Providing interest rates and penalties helps the lender not to lose money over a period of the loan and ensures that the buyer pays on time. If the loan is to be repaid in chunks, the payment plan and payment schedules should be indicated in the contract along with the terms for payment defaults.
A written loan agreement also allows lenders to protect themselves from unforeseen occurrences. You can download our loan agreement forms here or agreement templates for easy access and download our templates to help you cut cost and save on money.
If you are doubtful about the idea of lending money to a relative, obtaining legal advice is worth it to save yourself from the risk of investing your money in a situation that does not pay off.
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3. Tax Considerations
Any type of loan that is processed with interest is subject to the same rules of taxation which governs loans between an individual and an unrelated third party, regardless if the loan was between a friend or a family member. The lender is obliged to report the interest payment as income on his annual tax return. On the other hand, if the borrower uses the loan proceeds for business, he will then be entitled to deductions amounting to the paid interest. However, in cases of a no-interest loans, the IRS typically taxes the lender in two different events: one is through an imaginary income and, depending on the loaned amount, may also be taxed for gift tax on the imaginary payment made by the borrower.
In the case of a loan with a rate of interest that is under or below the applicable federal rate, the IRS will treat the transactions in a similar way as with a loan with no interest; however, the amount of “imaginary interest” will be equivalent to the difference between interests calculated at the applicable federal rate and the amount of interest actually paid.
Loans for $10,000 or less are exempt as long as the loan proceeds are not used to purchase income-producing assets. For income tax purposes, imputed interest on loans for more than $10,000 but less than $100,000 is limited to the borrower’s net investment income for the year, and no interest is imputed if the borrower’s net investment income is less than $1,000. However, the imputed interest rules will apply for purposes of the gift tax.
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4. Consider Other Options
Sometimes the idea of borrowing money from a kin or a friend is actually more hassling and tedious than going straight to the bank. In fact, most people agree that loans provided by family and friends usually result to low offers or an unsatisfactory deal. If you are wanting to make a loan but you do not have the required paperwork needed to file one with the bank, and you were not able to make a good deal out of a friend, you can consider peer-to-peer lending sites that give lenders the flexibility of choosing their own interest rates as well as the time frame for the loan. To reduce the risk of defaults, borrowers are subjugated to a rigorous background and verification screening.
A credit union is also another option to borrow money such as cooperatives in the workplace, in an area of residence, or in groups and organizations where members are allowed to loan money with low interest rates.
Because of the economy worsening as time goes by, loans made between friends and family members have greatly increased. The number of parents who lend money to their children has risen up to 31% in the last 6 years, and the number of people who submit themselves to informal lending has risen up to 80% in the past 6 years.
The influx of loans and people lending money informally has also heightened the number of legal disputes, misunderstandings, and brawls between lenders and borrowers, families versus families, and friends who turn against each other. Having a legal written contract is one way to settle all misunderstandings by formally describing that debts have to be repaid and that a loan is a loan and is not a gift.
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