Family loans: How to dodge the drama

Financial advisers don't always agree, but when it comes to lending money to family, there's consensus: Tread carefully.

If an adult child needs help buying a first home or has a promising business idea, a family loan can be a fast and convenient option. But there's a risk of drama down the road.

Here are tips for lending and borrowing money among relatives.

PROS AND CONS OF FAMILY LOANS

There are advantages of a family loan for a borrower: no credit check, low or no interest and flexible payback terms.

It can also be a way to help young adults learn about financial responsibility, says Walter Pressey, a retired financial industry executive in Boston who loaned money to two of his four adult children with LoanKin, a loan servicing website.

But loans can be uncomfortable for both the giver and receiver. If you're the family ATM , you may have trouble saying "no" and thus jeopardize your own finances. If you're the one asking family for money, you may feel a sense of obligation over payments that strains the relationship.

Before loaning money, financial planners recommend considering the impact on your own goals, such as retirement. And while your loved one may have every intention of paying you back, be sure you can afford to part with the money if things go south, says Eric Gabor, a certified financial planner with Eagle Grove Advisors in New Jersey.

Family loans may also come with tax considerations, whether the lender charges interest or not. Charge zero interest, and you may face a gift tax; a borrower who receives a gift may have to report it as taxable income. Tack on an interest charge and you must follow IRS-specified guidelines for the rate you charge and report it as income.

BORROWERS: EXHAUST OTHER OPTIONS FIRST

When weighing the pros and cons of a family loan, also consider alternative options, including a personal loan borrowed from a bank, credit union or online lender that can be used for any purpose.

Personal loans from credit unions and online lenders typically have more flexible qualification requirements than a bank loan. Taking out a personal loan co-signed by a family member who has good credit may require more disciplined payback than borrowing directly from the relative, and paying it back can build your credit score. Bear in mind that not repaying a co-signed loan can ruin your loved one's credit as well as your own, and he or she will have to repay it if you cannot.

LENDERS: ASSESS THE REASON FOR THE REQUEST

If you are lending the money, try to set your emotions aside and look at the reason for the loan. Has your family member been rejected by banks and other lenders? If so, why? Will your loan help promote good financial decisions?

"Good" reasons for a loan could include buying a house or starting a business, while "bad" reasons could be paying credit card or gambling debt, Gabor said.

When Pressey's daughter shared her worry about her high credit card balance, he used the opportunity to help her in two ways. First, he offered to lend her money to pay off the debt and pay him back at a lower rate. Second, he taught her how to use a credit card properly going forward, by paying off each month's balance in full, not just making the minimum payment.

His daughter repaid the loan without any issues, he says.

SPELL OUT TERMS

One way to avoid future problems is to use a family loan agreement, says Derek Tharp, a certified financial planner at Conscious Capital in Cedar Rapids, Iowa. Signing a promissory note with the family members involved and getting it notarized may seem impersonal, but it can prevent hurt feelings and disputes.

The key to smooth repayment is making sure the family member making the loan clearly spells out the loan terms, says Charley Moore, founder and CEO of Rocket Lawyer, a website that provides templates for legal documents, such as for family loans.

That includes defining when the loan should be repaid, whether it's due in fixed installments or a lump-sum payment, and what happens if the borrower has trouble with repayments.

Pressey included his children in the decision-making process when setting the loan terms to make sure everyone involved understood the agreement. He said his daughter decided on the amount she would pay and when she made her payment, so that she was able to work it into her budget and build healthy financial habits.

This article was provided to The Associated Press by the personal finance website NerdWallet. Amrita Jayakumar is a writer at NerdWallet. Email: ajayakumar@nerdwallet.com. Twitter: @ajbomb