A family loan agreement is a legally binding contract between family members. These members can be a relation by marriage or blood. One member acts as the lender while the other member is the borrower. It is also known as a simple loan agreement between family and loan agreement form between family members.
When borrowing money from family, the family member may ask you to pay an interest rate. This rate will be lower than what bank charges, so it will be worthwhile. Usually, family members do not charge interest, but it depends on the relationship you have with the person.
The loan agreement is similar to any other loan contract that you sign. It will stipulate the date by which you should repay the loan amount, the interest rate, and any other terms and conditions, like how the family member will hand late payments and defaults.
Who Takes the Family Loan Agreement? – People Involved
The family loan agreement is like any other loan agreement. It is made between the borrower and the lender. Their names and addresses should clearly be stated in the loan agreement, along with the relationship they have. This safeguards both people.
Having a loan agreement in place when borrowing from your family stipulates the terms and conditions. By sticking to them, you will not only be able to clear the loan, but also ensure your relationship with the family member does not get adversely affected.
Loaning Money to Family
Lending money to the family always sounds like a good idea. The borrower does not have to worry about approvals and high-interest rates. If they pay interest, the money stays in the family rather than going to a third party.
You should be ready for loan to family member tax implications. Remember, even if you do not charge interest, IRS will assume you are getting interested and pay taxes on it while the borrower can get a tax deduction for interest they have not paid. It is best to consult a tax adviser to find out what is the minimum interest rate for a family loan. If the interest you charge is too little, the IRS will view the family loan as a gift. Hence, you should be aware of the prevailing gift taxes.
Check out the applicable federal rates and check with your tax adviser the minimum rate to charge so that you don’t have a problem with the IRS. At the same time, it should not be above the IRS threshold limit so that you do not get taxed for the interest you receive.
Purpose of the Family Loan Agreement – Why Do You Need It?
Lending money to family is one of the easiest ways to mar your relationship with the person. If the person cannot or will not repay the loan, you will end up resenting them. It can pull other family members into the dispute and also cause issues with your spouse. So, even after knowing the emotional implications of lending money to a family member you want to go ahead, it is best to put everything in writing.
A family loan agreement is legally binding; you and the borrower will have to adhere to the terms and conditions. It also proves to you that the borrower is honest and intends to repay the borrowed amount when they agree to sign the loan agreement. The document clearly states the amount that was given, the expected date of return. Once you and the other person sign it, it becomes a promissory note.
The purpose of the agreement is to detail the terms and conditions of the loan and to ensure that the tax authority does not misconstrue the loan as a gift to the borrower, as it will have tax implications. Also, the borrower cannot wriggle out of repaying you at a later stage, claiming that they did not know they were expected to return the borrowed sum.
Contents of the Family Loan Agreement – Inclusions
A family loan agreement has similar basic inclusions like any other lending agreement. Some of the essential inclusions in the agreement include the following:
- Name and address of the lender and borrower
- The relationship between the two parties
- The amount that the lender is lending to the borrower
- The date when the amount will be provided to the borrower
- The payment schedule – whether the borrower will pay monthly, quarterly or half-yearly
- The fixed date on which the borrower will make the repayments until the loan and the interest have been paid in full
- The installment that the borrower will pay
- The compounded annual interest rate on the borrowed sum
- How the lender will handle a default and/or late payments
- Application of the payments – how the repayments made by the borrower will first be applied to the interest and thereafter to the principal.
The loan agreement should be treated like any other legal document. So, both parties should date and sign the agreement. It is also best to get two people as witnesses so that there is no reason for doubt or misunderstanding later on. Finally, to ensure it is legally binding to both parties, get the agreement notarized due to non-payment.
Make sure you enter all the necessary inclusions to avoid disputes in the future. This way, you will be able to ensure your family member repays the borrowed sum, and you also do not jeopardize your relationship with the person.
How to Draft the Family Loan Agreement?
When drafting a family loan agreement, keep the following points in mind:
- Mention the complete name and address of the lender and borrower.
- State the amount of money being lent in letters and numbers to prevent either party from claiming miscommunication at a later stage.
- Be specific about the date when the money is to be lent and the date when it should be returned
- Make sure the interest rate is reasonable, lest the IRS views it as a gift, making the lender liable for gift taxes
- The payment schedule should be clearly mentioned. You can choose between periodic payment, balloon payments, or a combination of both.
- Penalty for not missing the payments or if the cheque bounces. Here, you can give the person a grace period after which you can levy the penalty or take the necessary action, which should be mentioned in the agreement
- What happens if either party breaches the loan agreement.
Even after creating a foolproof loan agreement, the person does not repay, and you can avail tax deductions in your tax returns, claiming it to be bad debt. However, you would have to prove to the IRS that you tried all possible measures to recover the money, and this includes taking the borrower to court.
[Also Read: Tax Agreement]
You and the borrower can negotiate the terms and conditions of the family loan agreement. Always ask the borrower for a detailed plan to find out how they intend using the money. This way, you will be in the driver’s seat. Ensure that the terms of repayment are realistic based on the finances of the borrower. Help them create a monthly budget, so that you can get monthly payments without a problem.
Benefits & Drawbacks of the Family Loan Agreement
Most people turn to family members after traditional lenders have refused them a loan. Hence, if you are the lender, you should realize that the borrower’s finances are not that great. The chances of default are high. Also, the borrower may take the repayment a little too lightly, causing tension in the family. Taking a loan from a family member does not help the borrower from building their credit history. So, if the credit history was poor earlier, it will remain the same.
You may also end up paying taxes for the interest amount that you receive from the borrower. This will happen if you charge a rate that is higher than the Applicable Federal Rate.
However, a family loan agreement can often be a way to help out a less privileged family member. It may make you feel good and also help the person in their hour of need. Usually, family loans help to consolidate debt, finance education, or buy a first home. So, it is never used in a frivolous manner.
Helping out a family member with a family loan may result in the person getting their finances back on track if they know they are obligated to repay the loan amount after signing the legally binding agreement.
What Happens in Case of Violation?
Remember, the borrower has approached you because they are financially on sticky ground. So, you should lend money only if you are ready to risk or lose it. This said the family loan agreement should have provisions to handle breach of the terms and conditions. The lender can include a fixed penalty for not sticking to the terms and conditions of the agreement. Or, they can always change the interest rate.
The key is to ensure that the agreement clearly states what would happen in case the borrower violates the agreement. That is why it is best to sample loan agreement between family members to draft the actual agreement so that each party knows what would lie in store for them if they do not adhere to the contract.
In the worst-case scenario, the lender can take the borrower to court for infringing the terms and conditions of the loan agreement. The court would decide the outcome of the case. You can also involve a third-party processor to facilitate the repayment and report each payment or default to the credit bureaus(1). However, this would have to do at the time of signing the family loan agreement. Here, if the borrower defaults, the third-party processor will report the default to the credit bureaus, causing the borrower’s credit score to drop.
Before signing the family loan agreement, it is best to weigh the pros and cons. You have to consider the consequences of not repaying the loan or demanding that the loan be paid in full if you are the lender. It could alienate family members and hurting the feelings of your loved ones. It could lead to a lot of stress for you and other family members. However, having an agreement allows you to imitate the formal lending process for a family member who is less creditworthy.
The agreement will keep the borrower on their toes, as it is legally binding, provided the lender is willing to enforce the terms and conditions of the agreement. Furthermore, having a written family loan agreement can satisfy tax authorities as well, so that the lender does not have to worry about gift taxes(2). But make sure you consult a financial adviser to get the interest rate fixed.