Family Loans: How to Borrow From and Lend to Family

Borrowing from family may seem like a low-cost option if you need money for a down payment on a home, to start a business or repay high-interest debts.

But mixing business with family is tricky.

A family loan can put your relationship with the lender — and their finances — at risk. Success requires clear communication and potentially a formal written agreement that details the loan terms. Family lenders must also consider IRS guidelines.

Here’s what to know about family loans, including the pros and cons, how to formalize a family loan and alternatives to consider.

Pros and cons of family loans

Pros

Easier approval: There's typically no formal application process, credit check or verification of income with a family loan. Traditional lenders often require documents such as W-2s, pay stubs and tax forms as part of the loan application process.

Cheaper loans: Since the loan is coming from a family member instead of a for-profit corporation, you may get a loan at a much lower interest rate than what a bank, credit union or online lender might offer.

Family loans won't likely carry the upfront origination fee that lenders sometimes charge, and your family member may also waive late fees.

Hardship options: Family members may be more lenient than lenders if you encounter a hardship, like a job loss or illness, letting you pause or suspend payments for a period of time.

Helps avoid risky loans: Family loans can help you avoid predatory no-credit-check lenders and payday lenders who use unfair lending practices, like charging unaffordable interest rates.

Cons

Potential for conflict: If the loan isn't repaid or the terms of the agreement are broken, it can lead to arguments and strain a family relationship.

The family member loaning the money must consider the chances of not getting repaid and the impact the loan may have on their own financial goals, such as retirement.

No credit building: Payments toward a family loan aren't reported to the credit bureaus, eliminating the opportunity to improve the borrower’s credit. Good credit scores can help you qualify for future loans like mortgages and car loans.

Tax implications: If the family loan is interest-free and over $15,000, the family member who loaned the money may need to file a gift tax return. If the loan includes interest, the lender must follow IRS interest rate guidelines and potentially report it as income.

Put family loans in writing

One way to avoid issues that may arise during the repayment period is to use a family loan agreement, which is a contract that spells out the terms and conditions of the loan.

Signing a family loan agreement and getting it notarized may seem impersonal, but having things in writing can prevent future misunderstandings. Be sure to include everyone in the decision-making process.

Basic terms for a family loan agreement should include:

• The amount borrowed and how it will be used.

• Repayment terms, including payment amounts, frequency and when the loan will be repaid in full.

• The loan’s interest rate. The IRS sets an applicable federal rate each month, which is the minimum interest rate allowed for private loans over $10,000 (under 1% for loans repaid in nine years or less).

• If the loan can be repaid early without penalty, and how much interest will be saved by early repayment.

• What happens if the borrower stops paying, whether it’s temporarily due to emergency, or entirely.

Alternatives to family loans

When weighing the pros and cons of a family loan, also consider alternative options that may provide more cash and less risk to family relationships.

Co-sign loans: Some lenders allow you to add a family member as a co-signer to a loan application. Doing so can increase your chances of qualifying and put less pressure on the family member, since they’re not providing the cash.

However, there’s still a risk of damaging your relationship. Failure to repay a co-signed loan can ruin the credit scores of both the borrower and co-signer, and the co-signer must repay the loan if the borrower can’t.

Personal loans: A personal loan is money borrowed from a bank, credit union or online lender. You get a chunk of cash that is typically repaid in monthly installments over a period of two to seven years. Personal loans can be used for nearly any purpose, including consolidating debt or home improvements.

Borrowers with good to excellent credit (690 FICO and above) may qualify for higher loan amounts and the lowest rates, which can range from 6% to 36% APR.

Small-business loans: If you’re looking for financing to start or grow a business, a small-business loan can provide higher loan amounts than what you would likely get from a family member, and timely payments can help your business build credit.

Options for startup business loans include microloans from nonprofits and crowdfunding. Established businesses have additional financing options, including from the Small Business Administration.