Is an intrafamily loan right for you?

Content Type: Article

Everything you need to know about loaning money to a family member, from interest rates to reducing awkwardness.

If a family member asks you for money to make a major purchase, a loan can sometimes be a better option than an outright cash gift. But dealing with money and family in this way does come with potential hazards. “Intrafamily loans, if not handled carefully, can lead to strained relationships, emotional damage and jealousy between family members,” says Erica Loftis, lending advisor at Regions Bank.

How do you safely loan to family? You’ll need to consider interest rates, payback terms and which documents you should have in place. Not only that but working with your Wealth Advisor on the deal can make the process run smoothly. To avoid an awkward Thanksgiving where money looms large, Loftis suggests the following four steps if you’re considering loaning money to family.

Consider your financial situation—and who is asking

Ask yourself if you can afford to make the loan. If your portfolio isn’t liquid enough or the amount would strain your personal finances, don’t be afraid to say no.

You should also consider the nature of the relationship with the family member. For example, would it make more sense to loan to a child than to a distant cousin? Because every family is different, that’s a decision you need to make. It also depends on what you know about the person’s financial history. “If you’re comfortable with the other party’s ability to repay the loan, then go for it as long as it doesn’t jeopardize your own financial stability and it doesn’t strain the relationship with the borrower,” says Loftis.

There are, of course, many situations in which you might want to say no. “You have to trust your instincts,” says Loftis. “You should consider saying no if you’re concerned about the borrower’s ability—or willingness—to pay.”
Use a contract with clearly defined repayment terms

Communicate openly and directly to take the emotional charge away from the loan. “The terms of the loan should be clearly defined and 100% transparent as should any consequences of not making the payment,” says Loftis.

When it comes to what interest rate to charge, follow the IRS’ guidelines for the applicable funds rate or AFR, which is published by the IRS every month. Loftis says that for an intrafamily loan over $10,000, you need to charge the minimum AFR to avoid tax consequences. “AFRs are less than traditional bank market rates,” she says, which should also be factored into your decision. A high-interest-rate environment will force the borrower to pay back more than they would when rates are lower.

Always make sure both parties agree on the payback terms. “These agreements can outline whatever terms the parties agree upon, as long as they align with IRS terms,” says Loftis. The IRS defines a short-term loan as less than three years, midterm as three to nine years and long-term as more than nine years. Each term has a specific AFR attached to it, so be sure to check before putting these details in the contract.

Additionally, Loftis suggests adding specific language and potential fees if the borrower defaults on the loan. This can be delicate with family but essential so everyone is on the same page.
Talk with a financial professional

Because of the potential tax implications of the loan, make sure to talk to a trusted financial professional. “Your Wealth Advisor can help with the structuring of the loan, defining some of those terms and repayment details,” Loftis says. “It’s also helpful to have that neutral third party to help with the family dynamics of the process.”

Similarly, your advisor can set up auto-debit, so the repayment arrangement feels more formal. “This can take some of the emotion out of the process.”
Consider the good your loan can do

Once all the details are in place, think holistically about how the loan can help your family member—beyond their immediate need for the funds.

For example, says Loftis, in the current environment of elevated interest rates, an intrafamily loan can be life changing if your family member is using it for a down payment on a home. “Your loan might allow them to qualify for traditional financing for the rest of the mortgage,” says Loftis. Your loan could serve as a springboard to building home equity and starting a family.

If you’re providing a loan to a family member with a troubled financial history, you can use the loan as an opportunity to instill good financial habits. Loftis says you might stipulate that the family member enroll in financial counseling, take budgeting classes or even work with a financial advisor. In this way, you can also give them knowledge that will help them throughout their lives.

As helpful as an intrafamily loan can be, remember that it’s not a gift. Talk to your Wealth Advisor before you decide to loan money to a family member.