Whether you’re loving or hating the low interest rates available on the market right now probably depends on where you are in life.
If you’re in the market to borrow for a major financial purchase or investment and have decent credit, the situation is looking mighty good. New car loans, mortgages, and even certain types of student debt are all being offered at rates at or below 4 percent.
Retirees, on the other hand, probably aren’t as jazzed. These persistently low interest rates are making it difficult for some pension fund managers to earn a sizeable annual return, reducing cash flows for seniors and putting the squeeze on some retirement accounts.
It all sounds like a situation of “haves” and “have nots” – but it doesn’t have to be that way, especially if there are members of either group that are related to one another. Enter the intra-family loan – a borrowing-lending strategy between relatives that CAN work quite well in the existing interest rate environment.
Mind the emphasis on the word “CAN,” however. The advantage of intra-family loans is that the borrower (i.e. the home buyer or car purchaser) can get needed funds at less than market rates, while the lender (i.e. the retiree looking for a better return) earns more than market rates simply by cutting out the financial institution. And because the loan is all in the family, both parties can feel good that they are helping out someone they know and love.
At the same time, lending to family members can often make for a bad deal. As the saying goes, “familiarity breeds contempt,” and such is certainly true when one familiar owes another money. Traditionally, the default rate on family loans is extremely high. Consider a young adult choosing between repaying his adoring grandma, or a faceless credit card company —a company with the power to determine his credit score for years to come. Can you guess who will get paid first? There are several ways to make an intra-family loan and avoid these pitfalls:
- Put the loan in writing. The loan needs to be spelled out in terms of the amount borrowed, the term of the loan, the frequency of repayment, and the annual rate of interest. Consider whether payments will be interest only, or interest and principal; whether the rate will reset over the life of the loan or stay fixed; and whether a demand feature should be included to allow the lender to call in the loan at any time. Be aware that you should set the rates equal to or greater than the “Applicable Federal Rates” (AFR) specified by the IRS for short-, medium-, and longer-term loans. While it is permissible to set the loan rates below the IRS amounts – even charging no interest at all – the lender nevertheless will have to report the appropriate AFR rate as taxable income, even if he or she never receives it.
- Automate the loan. By setting up automatic payments from the borrower’s account to the lender’s, you can avoid the regular temptation to the borrower of letting a payment slip, “just this once, because Mom won’t mind.”
- Consider securing the loan. If the loan is made to help a family member buy a home, a car, or other property, you can ask for a secured interest in the purchased property, to limit the loss of money in the event the loan is not repaid according to its terms. In the case of residential real estate, this means the loan becomes a mortgage, and the borrower is thereby eligible to claim the interest payments as an itemized deduction.
- Consider penalties and/or demand terms. It’s hard to secure a loan made for college expenses or to help a family member pay off credit card debt, but you can specify conditions for calling back the remaining principal, or consequences for when the loan terms are not met. For example, a student loan might become payable in full if the borrower fails to maintain a certain grade point average. (Whether the borrower will have the funds to pay off the loan under these circumstances is a different matter that also deserves a thought.)
- Keep track of the loan the way a third-party loan servicer does.Keep a record of the dates and amount of payments. If a payment is late and the loan specifies a late fee, you can quickly calculate this fee from the record. If the loan principal is being amortized over the term, set up a spreadsheet that allocates each payment between interest and principal. (You can find an amortization schedule template at office.microsoft.com or at docs.google.com.) You will need this schedule for reporting taxable income to the lender or, in the event that the loan becomes uncollectible, for reporting a capital loss of the outstanding principal.
Treating an intra-family loan as a transaction between strangers improves the chances that the loan will truly be a win-win for both borrower and lender. It’s a good idea, too, to consult a financial advisor before deciding to make the loan. The advisor can tell you the tax implications of the loan you are considering, and help you design a structure that works for both borrower and lender.