If you decide to become a lender to loved ones, because you feel you must, follow these six rules to make the transaction best for all concerned:
1. Only lend money you can afford to lose. This seems like a no-brainer, but it’s worth remembering. Think of it like gambling: Only lend up to the amount of money you’d feel comfortable placing on the table in a game of roulette or craps. Either way, maybe you’ll collect; maybe you won’t.
2. Get it in writing. Draft a loan agreement that’s signed by both parties. If adjustments need to be made later, you can then amend the agreement.
Seem too business-like for helping out a friend or relative? It’s not. If you were going to share a condo by the beach, you’d enter into a time-share agreement with the other party to avoid future misunderstandings. The same logic applies to a loan.
Only lend up to the amount of money you’d feel comfortable placing on the table in a game of roulette or craps.
Putting everything in writing goes a long way towards preserving your relationship because it’ll prevent misunderstandings and clearly lay out each party’s responsibilities and benefits.
3. Set a repayment schedule and amount, but be flexible about the terms. If the repayment amount is $200 per month, prepare for the possibility that your borrower will pay you just $50 or $100 in a given month due to tight times. If you continue receiving less than expected, you and your borrower may want to adjust the repayment schedule to lower monthly amounts.
Just insist you get paid something every month. Otherwise, you might find the person owing you money will choose to make no payment because he or she can’t make the full payment.
4. Consider charging a small interest rate. This will help compensate you for taking the risk, let the borrower feel like you’ve received something for your generosity and help you avoid tax problems.
The Internal Revenue Service (IRS) has rules about person-to-person lending, even among family members. If you charge interest, the IRS expects the rate to be at least what it calls the Applicable Federal Rate (AFR); currently that’s 0.48 percent for loans of up to three years; 1.82 percent for loans of three to nine years and 2.82 percent for loans over nine years.
If you make an interest-free loan, you may then be subject to tricky tax rules requiring you to pay taxes on interest you should’ve charged. (See this MarketWatch article for details.)
5. Keep track of the balance on a spreadsheet. And be sure your borrower does, too. This is crucial because losing track of payments made — or not made — means somebody may believe they’ve been screwed.
The spreadsheets should note not just how much was paid, but how the payments were made: cash, check, money transfer, etc. If you’re getting paid by check, you might even want to provide a receipt with a copy for yourself, noting the date, the amount paid and the balance due.
6. Don’t let money get in the way of your relationship. This is, far and away, the most difficult rule to follow. In fact, you may want to put into the written agreement that the financial arrangement is separate from your relationship and will have no bearing on it. Good luck with that one.