Banks are still only offering clients a whopping 0.50% per year and only 0.91% for the most generous savings accounts. Clients in search of a home equity loan may be hard pressed to find an interest rate below 6%. Many families are noting this spread and taking the middleman (i.e. bank) out of the equation. The financial benefit with this approach does however come with certain risks.
Don’t forget about due diligence
Even though the borrower is family, you should still go through the process of investigating the credit worthiness of the borrower. Behavior alone is not a determining factor in their ability to pay you back and neither is their word. Take a step further and request that the borrower provide you with a credit report so you can learn what their debt levels are at and if there have been any instances in which they missed payments.
How should this be reported?
Regardless of the type of loan, the terms of the agreement should be detailed in a signed contract. Even though you are family, it should be treated as a business transaction to ensure that the borrower pays the lender according to the terms. Specifically, the contract should detail the principal amount, interest rate, repayment schedule, names and addresses of both parties, as well as any other relevant information.
For tax purposes, the interest income the lender receives should be reported on line 8a of Form 1040 and summarized on Schedule B if they have over $1,500 in interest.
Lending money to family doesn’t come without risks
Lending money to family can be a catch 22 because you should care for family in their time of need but also want to be paid back. The borrower can take advantage of this situation and skip payments even if the terms are explicitly stated in a legal contract. It can certainly get awkward during family gatherings which will make it difficult for the lender to request payment.
The gift that keeps on giving
Once you’ve lent some money to a family member, you may become a crutch for them. It depends on what the money will be used for but most investments require follow-on funding which can become costly. If it is just a home equity loan and the terms are explicitly stated, then that is a different story.
What happens if the lender needs the money back?
Yikes! If you recently were laid off and underestimated the amount of money you would need in your emergency fund, you may have to ask for the money back. It is best only to lend money to a family member if the loan represents a small percentage of your liquid assets or less than 5%.
More Finance Questions? Ask a finance professional online.
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