Introduction
If you ever find yourself in a situation where you are contemplating lending money to a family member or friend, make sure that your finances are in order first. Mentally run through all of the possible scenarios and even potential alternatives before dolling out any favours, considering the relational and financial stress that lending a large amount of money could cause.
When you borrow money from a bank or credit union, you sign a legal contract with the institution. Similarly, a friendly loan agreement can help you make some basic ground rules. We have put together some basic terms to include in your agreement along with a few things you should discuss with the person you are lending money to.
Things to include in your loan agreement
It would be wise to draw up an agreement regardless of the kind of relationship you have with the person. The agreement is supposed to protect both parties from disagreements later on. A loan agreement between two individuals is simpler than a bank contract, but it still holds similarities.
A friendly loan agreement should contain the following terms:
- The amount borrowed
- Interest rate, if applicable
- Repayment plan, monthly instalments over a fixed period or one lump sum repayment on a specific date
One of the most important things to discuss in a loan agreement is what will happen if the borrower can’t or won’t pay it off. If someone needs additional time to repay, will that be okay with you? What if someone refuses to pay it off? The loan agreement should include your recourse in case of such circumstances, including but not limited to:
- Adding penalty costs to the loan amount
- Modifying the loan terms to accommodate the borrower’s situation
- Taking ownership of the collateral
- Pursuing legal action, if applicable
What if the borrower defaults on the loan?
Like any loan contract, the borrower is legally responsible for the debt. If they fail to stand by the terms of the agreement, the lender can take legal action against the borrower. With the loan agreement as proof, the lending party can sue in small claims court.
How do we keep the relationship protected?
Even decades-old relationships can crumble when the conditions of a loan agreement are violated or ignored.
Communication is the key to making sure your relationship remains unbroken. If the borrower is struggling to pay it off, it’s better to be honest about it and discuss alternate options rather than ignore it. It’s best to keep the lender in the loop to avoid animosity between the two parties.
Tax implications on friendly loans
In the case of a friendly loan, both the borrower and the lender have to deal with the IRS, although most of the responsibilities, though most of them fall on the lender. IRS will always want stellar proof that it’s a loan and not a gift. That means charging and collecting an interest under the IRS rules. As of last year, the minimum annual rate for short-term loans was 4.8% and 4.15% for mid-term loans. In the case of loans longer than 9 years, the annual rate is 4.02%.
If the parties involved are not charging and paying at least the minimum interest, the IRS could deem the money a “gift” and apply gift taxes.
Conclusion
Loaning money to family members or friends can be awkward if proper precautions aren’t taken beforehand. Agreeing on the repayment terms and drafting a written agreement is important to avoid miscommunications and make the terms favourable to both parties involved. If the borrower is unable to pay it off, you can consider changing the terms of the loan or in case of non-payment, you can take legal action too. We hope this helps clear your doubts about how to safely lend a loved one money without damaging your relationship with them.
