What do you need to know while taking out a loan from friends or family?

According to a 2018 Finder report, people in our country owed almost $184 billion annually to their friends and family.

So, if you are going through financial hardship, you might think about turning up to your friends or family to borrow money. But taking out a loan from your friends or family can strain your relationship and create hard feelings too if your expectations aren’t met or you fail to make payments on time.

However, if you can’t see any other way out apart from borrowing money from your family or friends, make sure to do it in the right way.

It would be a bad idea to borrow money from your closed ones now and then. Here are a few situations that you can consider for taking out a loan from your friends or family, like:

  1. 1. When you don’t have enough credit score to take out a personal loan
  2. 2. You need capital to start a small business
  3. 3. You don’t have an emergency fund to cover sudden expenses
  4. 4. You want to pay off your existing debts

Tips to follow while taking out a family loan

You might think that taking out a family loan is an internal matter of your family. But the IRS (Internal Revenue Service) considers money transfers between family members as gifts. And therefore, it might be subjected to tax.

So, you need to take some steps so that your loan seems legitimate in the eyes of Uncle Sam. And to make sure that there won’t be any confusion between you and your family member regarding the loan you are taking out.

1. Set up a repayment plan

If you don’t set up a repayment plan, complications may arise about paying off your loan. So, while taking out a loan from your family or friends, make sure to set up a repayment schedule. Also, it will help you to keep a track of your payments. And try to make payments always on time.

2. Pay interest

If you are taking out a loan of more than $10,000, it would be better to make interest payments. Otherwise, your lender has to pay taxes to the IRS on the forgone interest amount.

So, ask your family member to charge an applicable federal rate (AFR) on your loan. It is the minimum amount of interest rate that your family member will charge to avoid tax implications. In July 2020, the AFR for:

  1. I. Short-term loans (one with a term of 3 years or less) is 0.14%.
  2. II. Mid-term loans (one with a term of more than 3 years but not more than 9 years) is 0.45%.
  3. III. Long-term loans (one with a term of more than 9 years) is 1.17%.

And the good news is, the AFR remains the same throughout the loan term even if the rate changes in the future.

3. Get your agreement in writing

While taking out a loan from your friend or family, it’s better to get your agreement in writing. It can help you to avoid straining your relationships as everything related to your loan will be mentioned in the agreement. Neither you nor your lender will have a scope of getting confused about the loan’s terms and conditions.

So, you can get a promissory note to get the agreement in writing and include the amount you are borrowing, the interest rate, and the repayment term.

4. Maintain records

You need to maintain records of your debt repayments like the dates on which you are making payments, how much you are paying every month, and the remaining debt amount.

It will help you to keep track of your loan and you can plan your budget accordingly to keep your financial planning intact. Besides, I would suggest you make payments by check or opt for automatic deductions from your checking account; because paying by cash can be tough to track at times! And it will ensure that you won’t fall behind making payments on time.

How to seek financial help from your friends and family

Well, asking for financial assistance from your family or friends can be a sensitive issue. You may feel hesitant to take out a loan from your friends or family. But when you can’t find any other way out, it’s better not to hesitate and seek financial assistance in the right way.

So, here are a few things that you can follow:

  1. 1. Be honest and explain to them why you need the loan and of what amount. Hopefully, they will understand the situation and lend you the money. But giving false explanations can break mutual trust and ruin your relationship.
  2. 2. Tell them about the other options that you have tried for taking out a loan. And why you became unsuccessful in those attempts. Also, explain to them the reasons behind the dire need for urgent money.
  3. 3. As I said earlier, chalk out a repayment plan with your family member or friend. It will reveal your eagerness for repaying the loan amount and thereby, it will strengthen your relationship too.
  4. 4. You need to make them understand that there is no pressure involved in lending money to you. Explain to them that if they can’t lend you money, your relationship will stay unaffected. And after explaining your situation, give them a certain amount of time to think about it and decide accordingly.
  5. 5. Be respectful to your friends and family even if they can’t lend you money. And if they help you financially, you can show your gratitude by sending a thank you note, giving a free hug, etc.
  6. 6. Always make payments on time and stick to the agreed terms and conditions. Don’t let your family member or friend repent about lending money to you.

Pros and cons of taking out a loan from friends or family

Pros:

  1. 1. The interest rate of a family loan is usually much lesser than that of commercial loans. So, you will have to shell out much less for your interest payments.
  2. 2. Your family member or friend may agree to lend money for a shorter or longer repayment period than a bank or credit union would offer.
  3. 3. You don’t need to have a good credit score to qualify for a family loan.

Cons:

  1. 1. If you fail to make payments on time, your family member or friend can take legal action against you.
  2. 2. Your credit score won’t improve as your family member or friend is not likely going to report to the credit reporting bureaus.
  3. 3. If you can’t adhere to the agreed terms and conditions or fail to repay the loan, it can cause tension and resentment in your family.

But before you take out a family loan or borrow from your friends, I would recommend you to consider these options:

1. Opt for a debt consolidation program

If you couldn’t qualify for taking out a personal loan to consolidate debts, no need to worry. In this situation, you might think about borrowing money from your friends and family.
But I guess, you might have not thought about a wonderful yet effective way to consolidate debts and get rid of them at the earliest. Yes, you can approach a reputable debt consolidation company to repay your debts. The debt consultants of the company can help you by negotiating with your creditors on your behalf to reduce the interest rates. Once they agree, you can start single monthly payments for your multiple debts and save money on your interest payments too.
And guess what? You won’t need a credit score to qualify for a debt consolidation program.

2. Look for small business grants

If you need money for setting up your small business, you can apply for small business grants that offer free money for startups. Visit Grants.gov to find out the grants provided by various government agencies in our country.
Also, you can check some of the corporate small business grants like FedEx Small Business Grant Contest, Halstead Jewelry Grant Award, etc.

3. Consider peer-to-peer loans

Unlike financial institutions like banks or credit unions, peer-to-peer lending enables you to take out loans from individuals or a group of people who are willing to lend money. You can find many peer-to-peer websites like Upstart, Prosper, LendingClub, etc. that connect borrowers directly to the lenders.
You can take out loans of a much lower amount like $1,000 and with a lower interest rate than the traditional loans. However, you will need to have a credit score of around 600 to 640 to take out peer-to-peer loans.

4. Opt for home equity lines of credit (HELOC)

By taking out a HELOC, the lender will approve a credit limit based on the equity in your home. This credit limit will be available to you for a time limit known as the draw period which is usually up to 10 years. After the draw period ends, you will get a repayment period, which is usually up to 20 years.
So, if you need money, you can consider taking out a HELOC because of its much lower interest rates. According to a recent Bankrate report, as of November 4, 2020, the average HELOC rate was 5.78%. And if you use the loan amount for renovations to your home, interest on the loan can be tax deductible.
However, make sure to be regular on making payments on the HELOC. Otherwise, it can lead to foreclosure of your home.

So, the bottom line is that, if you need urgent money, taking out a loan from your friends or family can be your last resort. You can consider other options before seeking financial help from your friends or family.

If you decide to take out a family loan, you can follow the above tips. And try not to strain your relationship as much as possible. At the same time, find out the sources of financial problems and try to solve them so that you don’t need urgent money.