Family Loans: What to Know Before Borrowing or Lending

Loaning money to family, whether you’re the one borrowing or lending, can be a convenient way for loved ones to help each other out of a financial bind. But before you enter into a family loan arrangement, we’re here to help you consider the personal and financial impact of these types of loans between family.

What is a family loan?

A family loan is exactly what the name implies. It’s a loan arrangement between family members where no bank or traditional lender is involved. Whether it’s for paying off debt or making a major purchase or investment, a family loan can be for any reason. One misunderstanding could do a lot of damage to both your financial arrangement and your family unity.

Pros and cons of borrowing from or lending money to family

Before making a family loan arrangement, both family members should consider how it can impact their lives.

Family loan pros:

• No interest or lower interest. A family member may not charge much of an interest rate, if they charge one at all. That’s a nice discount compared to typical lenders.
• Your credit history isn’t a factor. Bypassing traditional lending means you can skip the normal credit check.
• More flexibility on repayment. It’s a good idea to have a recurring payment due date, even for a family loan arrangement. If you have trouble making a loan payment or two, your family member may give you a bit of grace and allow you extra time to repay them.

Family loan cons:

• It could strain your relationship. In a perfect world, a family loan is repaid on time under terms that all family members are comfortable with. But in real life, bumps happen along the way. And if the family members have a disagreement about the loan, it can create a tense environment for the whole family.
• It does not help strengthen your credit history. Since this kind of loan isn’t reported to the three main credit bureaus, future lenders won’t see that you made all of your family loan payments on time, as they would with a traditional loan.
• You may not get your money back. If you’re the lender, consider the possibility that some or all of the money may never be paid back. Think about all the ways you may be personally impacted if the loan isn’t repaid.

How to create a family loan agreement

When borrowing money from or lending money to family members, it's highly recommended that the transaction be formalized in some kind of written agreement between all parties. A family loan agreement can help prevent misunderstandings and maintain healthy relationships. Here are tips on how to create one:

• Open communication
  Start by having an open and honest conversation with each other. Discuss the terms of the loan, including the amount, interest rate (if any), repayment schedule and any collateral or guarantees.
  
• Seek legal advice
  Depending on the complexity of the loan agreement, it may be wise to consult with a lawyer or financial advisor. They can provide valuable insights and make sure your agreement complies with local laws and both people are protected. It's also best to consult with a lawyer for bigger loans or loan agreements with family members outside of your immediate family, like in-laws rather than parents or siblings. Consider the cost of getting the agreement drawn up and who will be responsible for paying for the legal fees.
  
• Document everything
  It's crucial to put everything in writing. Create a loan agreement that outlines all the details of the loan. You can find do-it-yourself templates online.
  
• Specify loan terms
  Clearly define the terms of the loan, such as the principal amount, interest rate (if applicable) and the repayment schedule. Be specific about when payments are due and how they should be made.
  
• Address potential issues
  Consider including provisions for what happens in case of late payments or defaults. Will there be penalties or late fees? How will disputes be resolved? Address these issues in writing.
  
• Get signatures
  Both parties involved should sign and notarize the loan agreement. This makes it a legally enforceable document, providing protection for both the lender and the borrower.
  
• Keep records
  Maintain thorough records of all transactions related to the loan, including payments made and received. This helps track the loan's progress and ensures transparency.
  
• Review and update
  Periodically review the loan agreement to check that it still meets both parties' needs. If circumstances change, consider updating the agreement accordingly.
  

Creating a family loan agreement may seem formal, but it can be useful if conflicts arise. By showing that both parties are committed to clear and fair financial dealings, a written, signed agreement fosters trust within your family— something far more valuable than money.

Alternatives to family loans

If a family member asks you for a loan, it may be easier for you to give it as a gift instead of a loan. This eliminates the risk and tension that come with loaning money to family. If you’re the one in need of a loan, another solution could be a personal loan from a traditional lender. This way, you get the money you need without involving your family — and you can pay off the loan in manageable monthly installments.

Decide what’s best for your family and finances

If you’re thinking about borrowing from or lending to a loved one, weigh the advantages and potential risks involved in family loans. If you make the decision to go forward with the loan, be very clear about how and when the loan will be repaid. If it's a large amount of money, you may want to get the advice of an attorney to make sure the terms are clear. Open communication and understanding can go a long way in keeping family bonds strong.