Lending Money To a Family

Shakespeare wrote that loaning money to a friend is a good way to lose both friend and money. So what do you do when a relative hits you up for a quick cash infusion? Tread carefully.
Often, the First Bank of Dad (or Mom) is the first place people turn when they have financial trouble, and many do have a need. A recent survey by Fidelity Investments found that 41 percent of U.S. households did not have emergency funds sufficient to cover three to six months of living expenses.

The first choice for cash during an economic catastrophe? Family and friends.
So if Uncle Bob puts the bite on you at the next family barbecue, here are some things to consider:# Do you really have the money? "It's the same rule as gambling: Don't loan what you can't afford to lose," says Ira Bryck, director of the University of Massachusetts Family Business Center in Amherst. Even if you're driving a Mercedes and living in a good neighborhood, if you haven't got ready cash lying around, a loan might not be feasible.

# What's the money for? Are you loaning your daughter $500 to put groceries on the table while your son-in-law is out of a job? Or does Cousin Ed want $15,000 to start a mink farm? And if you're loaning money for a small business, is the venture stable enough that you're comfortable with the risk?

# Is the borrower likely to repay you? Look at the person's past behavior. If someone consistently borrows money and never pays it back, chances are he has no intention of repaying you.

# Could the loan cause a rift in the family? This comes up a lot with siblings who borrow from parents, says Bryck. The one who doesn't get the loan thinks the parents are playing favorites. Or the siblings accuse the borrower of draining the inheritance. Bottom line: If you're the lender, it's your money to spend. But be discreet if you want peace in the family.

# How much will the loan cost you, and is it going toward something that you value? If your nest egg earns 7 percent annually, and a family member wants to sideline $20,000 for five years, the real cost is $28,052. But you might feel it's a smart move if the cash helps Dad hang on to the house or enables your nephew to finish medical school.

# Does the relative have other options? If the kids are in the habit of going to the Bank of Dad because the rates are so good, it might be time to introduce them to your local loan officer or credit union. Conversely, if their credit is so poor that they can't qualify, you need to know why.

# Can you easily live without the money for the term of the loan? What will you have to do without if you give up the money? Even if you're "only" taking it from savings, will the loan rob you of a much-needed cushion if you're the next one in the unemployment line?

Saying yesFor larger amounts, put the agreement in writing.
"The worst thing you want to do is ruin the relationship," says David Bendix, a certified financial planner and president of The Bendix Financial Group, based in Garden City, N.Y. "Problems usually occur when there's nothing in writing. Seven, eight years down the line, [people's memories] get fuzzy. Include the amount being loaned, the interest rate and the payback schedule. The borrower and lender should collaborate on the terms so it becomes a true partnership and each side buys into the agreement. And avoid balloon payments in favor of regular amounts that coincide with the borrower's pay schedule.

The lender should run it by a lawyer or accountant. Then both parties need to sign it.
"It's always good to have a witness and have it notarized, to make it as official as possible," Bendix says.

But asking for a written loan contract from a family member is like asking your intended to sign a pre-nup. The implication is "sure, I love you -- but ..." If you've decided the person is a good risk, and you want to make the loan, treat this as just another part of the deal.

And remember, your relative came to you for money, not the other way around. Here are four ways to approach the topic:
Blame the professionals. Your accountant or financial adviser absolutely insists on it. "It's not easy," Bendix admits. "Say, 'This is the way my adviser wants us to do the agreement.'" Let's hope, he adds, the borrower will be grateful for the loan and eager to demonstrate he or she is a good risk.

Blame the media. Mention that news report, online article or episode of People's Court that illustrated the damage interpersonal loans can inflict on relationships, and that the best way to prevent problems is with a written agreement.
Blame the IRS. "I'd love to loan you the money, but I've got to get something in writing in case I'm audited."

And last but not least effective, allude to a prior bad experience. Say something like, "Since I've had a problem in the past, (keep it purposefully vague), I learned that it really helps everyone to put a little something in writing."

And make sure the terms include a fair interest rate. If you have to pull the money from savings, you're losing that interest for the duration of the loan. Bendix recommends a market-based interest rate.
"Otherwise, it could be considered a gift," he says.
Keep a record of every payment, so there is never a question of how much of the loan has been repaid. Accept payments by check and give the borrower a signed receipt each time.
If you have the money but aren't sold on the way it will be spent, offer a loan to help with a different financial burden, says Bryck.
"If I can say 'I'm helping my grandchildren with their college education,' that might sit better than, 'I can't believe my 45-year-old son-in-law can't make the mortgage.'"

The tax manThe IRS assumes that a loan earns interest, and expects you to declare that income on your taxes.
The IRS even calculates a minimum interest rate it requires you to receive. Known as the applicable federal rate, the figures are published monthly in the agency's Internal Revenue Bulletin.

If the IRS believes the loan is really a gift in disguise, it will require the donor to file a special tax form at the end of the year. While the IRS permits a certain amount of tax-free gifts over a lifetime, once the giver has exceeded the limit, he or she will be liable for taxes on the gift.
But there are some general exceptions to the federal gift tax, according to the IRS, including: an annually exempted gift amount; tuition or medical expenses paid for someone else and (for the most part) gifts to a spouse.

In addition to federal regulation, "different states have different rules," says Rudy D'Agostino, partner in the Longmeadow, Mass.-based CPA firm of Meyers Brothers PC. "You want to check the rules locally."

Best bet: if the transaction is a real loan, charge an interest rate and make sure there is an ongoing paper trail, including a loan agreement, proof of repayment and plenty of receipts.
In spite of the extra paperwork and mandatory interest, borrowers -- especially those with less than perfect credit -- stand to get a better deal with a friend or family member than on the open market, says Bendix.

"It can be a tremendous benefit," he says. "The reasonable rate is going to be so much better than for any other non-secured loan."
Saying noJust because someone asks for money doesn't mean you have to give it. But it's more difficult saying no to family because, chances are, you want to preserve the relationship. If you don't have the cash, or if the loan would strain you financially, tell the potential borrower that you just don't have the money.

If you have it, but don't want to make the loan -- or suspect the person really wants a gift -- you can invoke a variety of reasons: the stock market's hit you pretty hard, kids or grandkids in college, family medical bills etc. If you run your own business, it's probably not much of a stretch to say that most of your cash is tied up there. Having money is one thing, says Bryck, being liquid is another.

When you say no, steel yourself. Sometimes a family member will take your "explanation" as an opening to negotiations. "I'm sorry, I just can't right now," is all you really need to say.
Family businesses also present their own lending problems, says Bryck. Sometimes, relatives see the company as a personal cash cow.
"But one of the cardinal rules of a family business is to treat it like a business, and not a family bank," he said.

Keeping the peaceOften, maintaining family harmony relies more on what you don't say. Remember to keep any loan request strictly between you and the potential borrower. The family doesn't need to know that Uncle Ned's business is going south unless he wants to announce it himself.

And if you haven't got cash for a loan to your oldest daughter because your youngest already borrowed $10,000, omit that detail when you refuse the request.
If you do make a loan to a relative, resist the urge to meddle. A parent with a ready checkbook might think "that they have some say in the person's lifestyle decisions," says Bryck. But that attitude is counterproductive.
"It sort of drags the borrower back into a childlike state."
Dana Dratch is a freelance writer based in Atlanta

source from : bankrate.com