All in the Family: Intra-Family Loans

September 26, 2012

The current low level of interest rates can be either a bane or a boon, depending on your perspective. If you are 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 are running between 3 and 4 percent, mortgages are now as low as less than 3%, and some federal student loans have again been pegged by Congress at 3.4 percent.

Then there are people who have money to lend:  investors or individuals close to or in retirement, who need to find a low-risk place to hold their funds while also earning a return. This group has a lot to complain about. With 30-year Treasury rates paying less than 2 percent and money markets earning virtually nothing (or even a negative return when you factor in bank fees), the return prospects look pretty bleak.

So is it possible to keep both groups happy at the same time? Yes, especially if they are related to one another. Enter the intra-family loan – a borrowing-lending strategy between relatives that CAN work quite well in the current interest rate environment.

Note, however, the emphasis on the word “CAN.” The advantage of intra-family loans is that the borrower can get needed funds at less than market rates while the lender earns more than market rates simply by cutting out the institutional providers. And because the loan is all in the family, both parties can feel good that they are helping out someone they know and care about.

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. As you might guess, the default rate on family loans makes the current foreclosure crisis look like a polite hiccup. Consider a young adult who finds himself having to make a choice between repaying his adoring grandma or a faceless credit card company which has the power to determine his FICO score for years to come. Can you guess who will get paid this month and who will get forgotten for another month, or two, or more, until the fact of there even being a loan is itself forgotten? Another problem with lending cash to kin is that there can be emotional strings attached, leaving the borrower not just in monetary, but moral bondage to a family member.

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 a standing order to transfer the 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 activating a demand of the principal outstanding or consequences if the loan terms are not honored.  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 thinking about.) Alternatively, if the loan is to be made to an estate beneficiary of the lender, there could be a provision specifying that the eventual inheritance will be reduced to the extent that the loan remains unpaid.

• Keep track of the loan the way a third-party loan servicer does. Keep a record of the dates and amount of payments; thus, 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.

The point is, setting up and tracking an intra-family loan as if it were an arm’s length transaction between strangers improves the chances that the loan will truly be a win-win situation 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 income tax and possibly wealth transfer tax impacts of the loan you are considering and help you design a structure that works for both borrower and lender.

Your end game:  not only to keep more wealth in the family and out of the hands of institutional lenders but to also make sure that at the next family gathering, everyone is happy and still on speaking terms.