A family loan agreement enables lenders to loan money to family members. It provides clarity about the terms of the loan and holds the borrower accountable.
Writing a family loan agreement ensures that the family members involved in the agreement can mutually agree on the terms involving the loan.
A family loan agreement is also known as a simple loan agreement between families is a legally binding agreement between two family members that clearly spells out the terms of lending money to a family member with the aim of being paid back after a given duration of time with an accrued interest. This agreement can also apply to lending money to close friends with an aim of getting back your money with an interest after a certain duration of time.
Family lending vs Bank lending
Family lending enables lenders to develop flexible loan terms that have been agreed on with borrowers that are not as stringent as those offered in a bank. This flexibility enables lenders to make accommodative alterations in the family loan agreement which can incorporate any changes the borrower is going through that may affect his/her ability to repay the loan. Bank lending does however offer emotional detachment from borrowers, therefore, enabling the lender to retain a positive relationship with the borrower
The family loan agreement used in family lending also enables lenders to refrain from enforcing loan payment by reducing or pausing the amount paid by the borrower. This factor can be beneficial as it not only enables the lender to assist the borrower with emergency funds, but it also ensures that when repayment with interest does take place, the money remains within the family and hence is not lost to external lenders such as banks.
A lender must be aware that there are likely risks attached to lending money to a family member. The most obvious risk is caused by lending money to a family member in the default of payment. Regardless of how reliable a lender believes the family member to be, there are situations such as unexpected unemployment that may prevent the borrower from paying the loan. This can lead to verbal arguments arising within the family which can destroy relationships built over the years and make relations among parties involved sour.
Family lending may also have a negative impact on lenders’ finances because it can reduce their funds affecting their ability to meet their needs. This may be caused by factors such as the low-interest rates lenders charge on account of the fact that the borrower is a family member. This can leave lenders in a precarious financial condition due to reduced financial gains from lending money to family members.
Protecting the Lenders
The risks imposed by lending money to family members can gravely affect a lender’s financial status. The family loan agreement can help reduce the risks posed by loaning money to family members and protect lenders. For lenders to benefit from the protection gained by writing a family loan agreement they should consider adhering to the following process:
Speak with a local attorney
First, lenders should speak to legal representatives to find out how they can protect themselves from the risks of loaning money to family members. Legal representatives will be obligated to inform lenders of any state and federal laws surrounding the family loan agreement.
Encourage the borrower to safely deposit funds
Secondly, lenders should encourage borrowers to deposit the loaned funds in an insured bank account or credit union until they require the money. This helps ensure lenders are confident the money borrowed is used for the purpose it was requested for in the first place.
Make the agreement
Thirdly, the lender should draft the family loan agreement, ensuring that the terms stated have been discussed with the borrower. The family loan agreement acts as proof of the arrangement made between lenders and their family members.
Finally, lenders should use collateral as a security pledge that the loan will be repaid by borrowers. Collateral protects the lender against loss of funds from a default of payment by the borrower.
Tax Implementation on Family Loan
One of the most overlooked areas of family loan agreements is tax implementation. This is because most people either neglect or are ignorant of the fact that family loans also attract tax due to interest incurred. It’s therefore of utter importance for individuals to loan amounts that do not exceed the IRS tax threshold. It is advised to the lenders to consult the tax advisor before setting the interest rate as they are generally needed to charge the Applicable Federal Rate (AFR).
NOTE: Other than federal law, lenders also need to abide by the state laws, for example, those governing usury. The interest rate they charge should not be considered extortionate under state law.
Components of Family Loan Agreement
Lenders must ensure that their family loan agreement is composed of all the necessary information for the document to effectively serve its purpose. It is therefore important that lenders compose a family loan agreement containing the following information:
The family loan agreement must contain the amount of money the lender has lent to their family members. The amount lent is also known as the principal amount which the borrower will receive from the lender. Stating it ensures that lenders have a record of the amount of money owed to them by borrowers.
Reason of lending
The family loan agreement must state a reason explaining why a borrower has taken the loan from the lender. The lender must discuss and verify that the reasons cited by the borrower are legitimate. This helps ensure that the lender can hold the borrower accountable for how the funds are used.
Expect getting repaid or not
Lenders must ensure the family loan agreement states whether they expect their family members to repay the loan owed to them. This ensures that borrowers and lenders can agree on expectations concerning a refund.
The family loan agreement should contain the lender’s interest rate. The lender must ensure that the interest rate stated is within any cited state regulations to ensure that the agreement adheres to the legal framework. Stating the interest rate ensures that the borrower is aware of how much interest is incurred in the period the loan is not repaid.
Late fees and collateral
The family loan agreement must also state any consequences lenders can impose on their borrowers if they stop making their repayment. This includes whether the borrower will be charged for late fees or if the lender will take any collateral. Stating this ensures the lender has proof that the borrower was well informed of the consequences attached to late fee payment.
Use of third-party loan servicer or not
Lenders must also ensure that the family loan agreement states whether the loan has been provided by a third-party servicer. Lenders that use third-party loan servicers enlist the help of another party to complete or provide the loan. Stating this in the family loan agreement ensures that the lender is clear about the origin of the loan.
Lenders must also state special considerations they are willing to make that may affect the family loan agreement. These considerations will ensure that the lender has thought through circumstances that affect the borrower’s ability to pay back the loan. The special considerations include:
- When borrower is ill: Lenders may state that should borrowers fall ill, they will be absolved from repaying, or the loan will stop gaining interest, etc. This ensures that lenders can flexibly adjust the agreement to the length the borrower will be ill, which can be a long or short period.
- When borrower dies: Lenders should also state what will happen if the borrower dies. In most cases, lenders will cancel repayment due to family relations with the deceased.
- When borrower cannot payback: The lender should also state what will happen if the borrower is unable to repay the loan. The term will help guide the lenders in handling borrowers who are caught in such a situation.
Lenders should also indicate the payment plans according to the time period that they have discussed and agreed on with the borrower. These plans help lenders monitor if borrowers are making their payments on schedule.
Payment spending plan
The lender must ensure that borrower provides a detailed account of how the money will be spent. The lender should ensure that the family loan agreement answers the following questions:
- Is the borrower required to communicate with you?
The lender should state whether the borrower is required to constantly communicate about how they use the loan. This can help the lender adjust the terms of the agreement according to how the borrower spends the loan.
- Are you allowed to suggest how to prioritize expenses?
The family loan agreement may also state if lenders can suggest how borrowers can prioritize expenses, especially if the lender does not expect a refund. This ensures lenders are aware of exactly how much control they have over the way the borrower spends the loan.
Building credits or not
Building credits enables lenders to hold the loan in an account and retain it only until borrowers repay their loans. It is a type of forced saving where the payments are reported to a credit bureau. It is therefore important that the family loan agreement states whether the loan is a credit builder loan or not.
Free Loan Agreement Templates
Following are free customizable loan agreement forms:
Family Loan Agreement
Promise to Pay
For value received, _______________________, (the ‘Borrower’) promises to pay __________________________ (the ‘Lender’) $__________ and interest at the yearly rate of ______% on the unpaid balance as specified below.
Borrower will pay ____ monthly installments of $_______ each.
Date of Installment Payments.
Borrower will make an installment payment on the ____the day of each month beginning ____________, 20___ until the principal and interest have been paid in full.
Application of Payments.
Payments will be applied first to interest and then to principal.
Borrower may prepay all or any part of the principal without penalty.
If Borrower is more than ____ days late in making any payment, Lender may declare that the entire balance of unpaid principal is due immediately, together with the interest that has accrued.
(There is no security since this is a family loan.)
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This agreement was signed and dated on the ____ day of _______________, 20_____
(Signed and dated by both parties; each party receives a signed original)
Interest Rates on a Family Loan
Even though interest rates may clash with the initial intention of offering the loan to a family member, they are a necessary evil to maintain professionalism. First of all, just like any other institution, you will be doing your money a favor by charging an interest rate since it could have earned a decent interest if it could have been using in a different manner. This way, you will be able to offset any losses that may occur during the loan period.
Remember! it’s is important not to set loan limits above IRS threshold limits.
This is because you will be required to pay a tax fee once this threshold is reached. To avoid this, utilize the applicable federal rate that is offered directly by the government. This will not only ensure that you get a decent interest rate but also, you will not be subject to any form of taxation.
Frequently Asked Questions
Before 1997, the Gift tax was applicable, and anyone lending their income to their acquittances was taxed. Currently, there are no taxes on individuals who loan money to their friends or family regardless of whether they are charged interest or not.
Similarly, the gift tax not permits the transfer of amounts as gifts up to $500 without any taxes. Loans that are not gifts, and are not to be paid back to the Lender, are not taxed either.
If you are looking to make things formal, it is best to draft a legal document to make an official record of the loan. You can decide to use a promissory note, which is a promise by the Borrower to the Lender to repay the loan amount by a specific date; or a loan agreement, which can be changed later.
Find out what the problem is. Are there any other ways in which you can help apart from financial support? You should keep in mind that money isn’t always the solution to all problems. Consult your family member or friend on whether you can help in any other way apart from loaning money.
There are two major things you should consider while lending the money:
1. Can you afford to lose the amount requested?
As a general rule while offering loans. You should only lend the amount that you can afford to lose. You should not go out of your way to break the bank on the money you had saved for your college fee.
2. Be clear about what you expect
You should draw up a formidable payment plan and a loan schedule that works for you. If your family or friend doesn’t agree with the schedule, then don’t lend the money to them.
It’s of utter essence however to note that family loan agreements are totally unsecured since the person borrowing the money is a family member or a close friend. This is to say that there are no assets taken as collateral in case the family member fails to pay back the money. So, how will you be able to collect back your money if the family member or friend defaults on the agreement? Well, the only solution that you will have is to go through legal action or through a small claims court. This way, you can be assured to get back your money from the family member legally.