There are two things that tend to be off limits when it comes to dinner conversation: money and politics. And for good reason, talking about finances can spoil relationships by creating resentment and misunderstandings.
But what happens when a family member is struggling to make ends meet and asks to borrow money? Whether you co-sign a bank loan or lend money outright, you’re putting your capital and credit on the line when becoming a bank of last resort.
Before writing a check or signing on the dotted line, experts suggest evaluating your own finances to avoid any hardships down the road and potential relationship problems.
Can you afford to make the loan? Consider your own long-term and short-term goals to make sure you can afford to help, especially if you’re close to retirement, says Suzanna de Baca, vice president of wealth strategies at Ameriprise Financial. “Sometimes it’s OK to say, ‘No,’ and that can be very difficult when you want to help a family member or have a family member in need.”
Co-signing a bank loan should also be considered as providing financial support, says Joseph Montanaro, certified financial planner at USAA. “You’re certainly at risk when you do that, and you have to plan on making those payments if the other person can’t.”
Experts recommend lending money only if you can afford to lose it since your loan is harder to collect than a loan from a bank. “You have to think you’re never going to see it again,” advises Randy Kessler, founding partner of Kessler & Solomiany. “Be prepared to never get it back. If you think you’ll get it back and you do, it’s found money.”
Why do they need to borrow from me? Ask why the family member is coming to you for capital and not a bank, suggests Montanaro. In most cases, he says credit issues prevent getting loans from a bank, in which case you must ask if it’s a safe risk for you.
Sometimes though, these risk pay off. “Sometimes there are fantastic things that happen with the money,” says William Kriesel, certified public accountant and partner in charge - financial planning at Bowers & Company. “It’s not always a bad idea. Certainly, it can be a great source of capital for a new home or business. Sometimes it makes sense.”
However, if you’ve a creditworthy borrower, this loan might make sense since it could generate more interest than a savings account.
Will the loan cause resentment? “Loaning money between family members can be complicated because of the financial and emotional component,” says De Baca. “Be as formal as you can to make sure the relationship isn’t affected.”
Be clear and distinguish whether the money is a loan or a gift.
Everyone treats money differently. “The hardest thing about lending money is not inflicting your belief system on everybody else,” warns Michael Goodman, certified public accountant and president at Wealthstream Advisors. It can be challenging for some people to lend money to family members and not question how they spend it. “Either you give the gift and move on or not. You can’t wrap yourself in the emotion of the person’s financial decisions,” he adds.
The loan can create resentment in a family especially if it’s not paid back. “Business decisions that are clouded by emotions are no longer just business decisions,” says Kessler.
Should you formalize the agreement? Experts agree that a formal agreement for any amount you’re not willing to lose could help prevent negative emotions. “The more formal you make it, the more obligated the payer will be,” says Goodman. He recommends hiring a lawyer to help structure the loan for any amount you’re not willing to lose.
“You can do a promissory note on your own but it’s better to have a lawyer look at it,” adds Kessler. If you decide not to use a lawyer, you can also sign the document in front of a notary public or someone who’s not a family member.
Should the loan affect your estate planning? Whether to include the loan in your will depends on the size of your estate and the loan amount, according to Goodman. “If it’s a parent helping a child and it’s a substantial amount of money, there should be some reconciliation in the estate planning. The will should have language that makes sure everything is equitable, including the loan, should the parents demise.”
What are other ways that protect you if your family member defaults? Since loans from family members do not have the same immediate repercussions as bank loans, depending on the amount loaned, Kriesel suggests considering a security interest in the collateral by filing a UCC-1 to help collect on the loan. “You can get a UCC on any asset that you want as long as they agree to it,” he says.
When you file a UCC-1, the money that you lent is perhaps better protected in the event another lender tries to collect on a bad debt. Under the Uniform Commercial Code (UCC), a UCC-1 perfects a security interest in personal property, meaning the lender has a lien on the property and the rights to that asset in the event any debtor forecloses or collects on the property. Filing fees are different in each state and, at present, are less than $100, according to Kessler.
How do you structure the loan? Experts recommend outlining the loan’s terms, such as due dates, late fees, and a payment based on an interest rate and loan term. “You need to make sure that the payment terms are easily managed by the person borrowing,” Kriesel says. If the loan payment is too high, there’s a greater chance that the borrower will default.
The term should take into account what the borrower can afford and the amount of money lent, says Goodman. A term that’s too long can create opportunities for problems while payments on a loan with a shorter term may be too expensive for the borrower. Experts recommend charging a market rate reflecting the risk and time period. So that the loan’s not considered a gift, the rate should be at least as high as the Internal Revenue Service’s applicable federal rate (AFR) for imputing taxable interest that’s published monthly.
“The decision to loan to a family member money is very personal,” says De Baca. “Examine your own situation, your relationship with that person, and where you are in terms of meeting your own financial goals.”