Borrowing from family or friends

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When people find themselves in a money crunch, sometimes the natural reaction is to turn to family for help. Parents, grandparents and siblings often are willing to lend a financial hand via a loan.

If you are asking for a loan of more than $100, you need to know the answers to at least three key questions:

•  Why do you need the money?

•  How do you expect to pay this back?

•  What are you doing so this doesn’t happen again?

If you can’t answer these questions honestly, you are not ready to ask for a loan.

If you can answer these questions, you need to know how to minimize the potential for resentment and destructive situations. These tips will help.

Know from whom you borrow

Ask yourself, “If I lose the money, what will be the outcome?” Relatives for whom money is an obvious emotional issue or those who really can’t afford to lose anything are not good lending candidates.

Put everything in writing

It may be sufficient in a very simple transaction to write a letter that specifies the terms of the agreement. But the best way may be to get a lawyer involved, particularly if it is a significant sum of money. That protects both sides.

Guide for setting up a pay-back plan

While a short-term loan of a couple hundred dollars might be arranged with a hug or a handshake, larger loans should have a more formal structure, say financial experts.

When you record the loan, make sure to include:
  • The names of the lender and borrower
  • The date of the loan initiation
  • The amount
  • The date by which the loan is to be repaid
  • The interest rate, if one is applied
  • The number of payments
  • How often payments are to be made (weekly, biweekly, monthly), and
  • The minimum amount to be paid.

The idea is not to try to create a legally binding document. You are simply putting the arrangement on a formal footing. This very basic process can make both parties more comfortable with the whole arrangement. It is a sign of respect, and it impresses upon the borrower that this is not a gift, not something that can be ignored or shrugged off later, and that repayment is definitely expected.

Know the tax laws

If the loan is for less than $10,000, it will probably escape the attention of the IRS. But if your loan is for a significant amount, make sure you understand the tax and other legal consequences, particularly if you die before the loan is paid off. The IRS considers loans that are forgiven as taxable income.

Give lenders something tangible

Specific collateral for lenders will ease concerns and ensure that they don’t lose everything if things don’t go well. In addition, if you are borrowing a large sum, the terms should include a fair interest rate. If your dad has to pull the money from savings, he’s losing that interest for the duration of the loan. You should also make sure there is an ongoing paper trail, including a loan agreement, proof of repayment and plenty of receipts.

Dangers of borrowing from family

Shakespeare wrote that loaning money to a friend is a good way to lose both friend and money. You must consider how the relationship would be affected if something goes awry. Should you be unable to repay the amount, how would your relationship suffer? What hardships would you inflict on the person making the loan? Could the loan cause a rift in the family? Family members — not just the relative advancing the cash, but others — may be resentful.

Also, be prepared for a “no.” Your relative or friend may not be in a position to loan you cash — or just may not want to. You need to be prepared to handle a negative answer with grace and understanding.

Jennie L. Phipps, Pat Curry, Dana Dratch and Amy Fleitas contributed to this story