The right way to loan money to family members

By Liz Pulliam Weston

With three words, you can sum up the most common advice about lending money to your relatives: "Don't do it."

Financial planners warn that intrafamily loans can lead to trashed relationships, shattered finances and even trouble with the IRS. People who've lent money to family members often complain about ingratitude, missed payments and strained holiday dinners. Even the borrowers grumble, especially when their benefactors start quizzing them about their spending.

"Suddenly, (the lender) is looking at the vacation they took and saying, 'They owe us money, how can they go on vacation?'" said financial planner Karen Ramsey, author of "Everything You Know About Money is Wrong." "The borrowers pick up on that judgment, and they get resentful."

Drawing up a contract

Yet still we lend. Why? The answer is contained in four words:

"They needed the money," said Sharon Conway, a Newburgh, N.Y., mother who, with her husband, lent $24,000 last year to their 30-something daughter and her husband. "They really got themselves into some debt, and they asked for help."

But the Conways' experience -- at least so far -- shows family loans don't necessarily have to be an unmitigated disaster.

The Conways hired a five-year-old company called CircleLending, based in Cambridge, Mass., to administer the loan. After deciding on the terms -- "the kids insisted on paying interest," Conway said -- CircleLending drew up the contract for a five-year loan at 4% interest and arranged to have the monthly payments whisked from the kids' checking account to the Conways'. The cost for this service: a $199 one-time fee, plus $9 a month. Given the monthly cost, it would be uneconomical to do this for loans where the monthly payment amount was small.

"We didn't want to be the cops when the loan was due," Conway said. "Now, the money comes like clockwork."

Daughter Terri Garrison said she's grateful her parents were willing to help, since some of the debt she and her husband Christopher had accumulated was piling up interest at rates in excess of 20%. Garrison also agreed with Conway's assertion that the younger couple treats the loan more seriously than they might have otherwise because a third party is involved.

"Money gets tight and you think about wanting to skip a payment," Garrison said, "but the payment comes directly out of our checking account."

$300 billion in informal loans

CircleLending also recently introduced a feature that would allow their loan payments to be reported to the Equifax credit bureau--something that could help the Garrisons build their credit rating.

CircleLending is, in effect, formalizing the world of "informal loans" between family members and friends, said CEO Asheesh Advani.

A former employee of the World Bank, Advani said he saw how such transfers help people worldwide buy homes and start businesses. In fact, the World Bank says informal loans and gifts between family members, friends and employers total more than $300 billion and account for up to 41% of household income in some Third World countries.

Of course, you don't need to hire a company to help you set up a family loan. And we'll leave aside the question of whether such lending in the industrialized world is "good" for either side. I trod that particular ground in "Should you bail out spendthrift parents?".

For right now, we'll just focus on the mechanics of doing it right.

Setting clear terms and communicating them is essential, said financial planner Victoria Collins, co-author of "Best Intentions: Ensuring Your Estate Plan Delivers Both Wealth and Wisdom."

Among the items you should cover:

Be clear (to the borrower, at least) that you expect to be paid back. This is particularly important if previous loans turned into gifts, inadvertently or otherwise.

You should discuss how much the payments are to be and when you should expect them. You also might talk about what will happen if the borrower is late or misses a payment.

Regardless of what you tell the borrower, though, Ramsey believes you should be prepared in your own mind for default.

Most of the time, she said, "they wouldn't be asking you for money if they could manage money in the first place."

Get good tax advice. Interest paid on family loans is taxable to the lender. But not charging interest may not be the right solution, since there's a tax bugaboo called "imputed interest" that can cause headaches for people who lend money to relatives.

If you don't charge interest, or don't charge enough, the IRS can essentially decide to tax you on income you didn't actually receive from the loan, said Mark Luscombe, an analyst for tax research firm CCH Inc. Also, loan amounts you forgive may be considered taxable income to the borrower.

There are loopholes big enough for most families to get through, but if the loan is for more than $10,000 or your family has made other gifts or loans recently, you'll probably want a tax pro's advice.

Draw up a contract. You can find contracts for promissory notes in stationery stores, or you can download forms from suppliers like Nolo Press for a fee. (Nolo also publishes a book, "101 Law Forms for Personal Use.")

Or you can just type up a statement that discusses how much you're lending, at what interest rate, the due dates for the payments and the other details you worked out. Make sure both parties get and sign copies.

Consider recording a mortgage debt. If you're lending money to buy or refinance a home -- particularly if it's a large amount -- consider having the debt officially recorded with the county clerk as a mortgage against the house. That will allow the borrower to deduct the interest on the loan, since the debt would be secured by the home, and gives the borrower the option of foreclosure.

Recording fees vary by country, but are usually somewhere around $200. Your county clerk's office should have information on how to record a mortgage debt, although many people hire attorneys to do the work. (CircleLending's fee for setting up and recording a mortgage is $599, plus an annual $99 fee for processing the payments and preparing the appropriate tax forms.)

Finally, and perhaps most importantly:

Don't lend money you can't afford to lose. Let's face it, even if you had the option of foreclosure, you probably wouldn't use it. That means you should avoid loaning money you can't live without, and you shouldn't let the rather healthy possibility of default ruin your relationship with the borrower.

"You could have a loving and deep relationship, and all of a sudden you're not speaking," Ramsey said. "The chances of it going sour are much higher than not . . . be prepared for that."

Liz Pulliam Weston's column appears every Monday and Thursday, exclusively on MSN Money. She also answers reader questions in the Your Money message board.