Question of the week:Our daughter has approached us about the possibility of borrowing $12,000 for a down payment on her first home. She's always been responsible with money, but we're still hesitant. What do you think about making loans to family? --G.L.
Dear G.L.,
You've hit upon an emotional topic that brings up strong opinions. We recently asked the Armchair Millionaire community about their experience with making loans to family members, and heard both the good and bad:
"I've loaned money to my parents and siblings and have borrowed from them as well over time. We have always treated these loans as serious financial obligations and have always paid interest at fair market rates, with no problems." --Ted C.
"In past years, I lent thousands of dollars to cash-strapped relatives and never was paid back one dime. Therefore, I have made it a strict policy to never lend money to relatives again." --Wendi H.
Most of us truly want to be able to help family members, but before you jump in, consider the consequences as rationally as possible. Ask yourself:
- Is the would-be borrower a good credit risk? Has he or she paid off debts on time in the past, or had a hard time keeping financial promises?
- Will the loan be used for something that will appreciate (such as a house) or return a value (such as a grad school education)? Or will it be used to pay off other debt or simply for living expenses?
- Can you afford it? If the only way you can lend money is to borrow it yourself--such as from a home equity loan or from your credit cards--then you can't afford to make the loan. I suggest that you lend the money only if you can afford to never see a single repayment.
If you're inclined to make the loan, go about it in a businesslike way. My checklist will help improve your odds for a positive outcome.
The Armchair Millionaire Checklist for Lending Money to Family Members
Treat it as a business transaction. Put everything in writing, including the loan amount, interest rate and payment schedule.- Set a reasonable interest rate. You might set an interest rate somewhere between what you would receive if you kept the money in a money market account and the rate the borrower would have to pay if they were to borrow from a bank. In this way, you would both come out ahead. Keep in mind, however, that depending on the size of the loan, you may need to charge the applicable federal interest rate, which is set by the IRS.
- Decide in advance what to do about non-payment. You might charge a late fee, or require a token monthly payment as proof of continuing good faith. You might allow an occasional "grace period" where interest still accrues. Spell it out in your agreement and make sure the borrower understands what will happen if they miss payments.
- Get help from a professional. Depending on the nature of the loan, it could carry significant legal, tax and estate planning implications. I strongly recommend seeking the advice of an attorney or CPA before finalizing the loan.
- Keep everything in perspective. Remember that in the long run, your relationship is more important than the money. If the loan goes south, you may decide to cut your losses in order to preserve the relationship.
THE BOTTOM LINE: Mixing money and families is never easy, so weigh the situation carefully before shelling out your cash for a loan. If you decide to lend the money, go about it in a way that will keep you and the borrower on good terms.
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Posted by: Millionaire | February 06, 2007 at 04:42 AM