Set strict contract terms for family loans
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Dear Dr. Don,
My adult daughter and her husband are losing their home, like many others (and due to some bad decisions on their part), and they need funds to move into a rental.
In the past, they’ve borrowed from my mother for occupational training, which hasn’t been repaid. My son-in-law’s parents helped make their mortgage payments when he injured himself and was out of work, and we helped with the utilities and medical bills. Our assistance was without strings, but I don’t know about theirs.
My daughter is asking for a little more than $4,000, and I have the funds readily available in savings. As a parent I know they need the help, and I don’t mind as I don’t want them or our grandchildren to suffer.
However, do I consider it a gift or a family loan? I don’t want to hinder them in getting a home in the future or to deprive the preschoolers. I also don’t want to feel like a jerk in the future when I see them purchasing non-necessities, while I sacrificed to build my savings.
Please advise how to properly handle this. I already have committed to helping them but am unsure how to proceed.
— Conflicted Kirtis
A gift should be freely given, meaning you don’t want it back and you won’t be constantly doing mental accounting about how the recipients spend their money in the future. If you don’t think you can get to that place, make it a loan. You can always decide to forgive the loan at a later date.
If you make it a family loan, make it official. Put together a written loan agreement that spells out when the loan matures, the payment terms, the interest rate and what happens when a payment is missed. There are websites available that can provide a loan agreement either for free or at a minimal cost.
How much interest do you charge on the loan? For a family loan of less than $10,000, it’s pretty hard to run afoul of IRS rules concerning the gift tax implications of an interest-free loan or a loan with a below-market interest rate because of the $10,000 gift loan exception for a demand loan. For the loan to fall under that exception, the loan proceeds can’t be used to purchase income-producing assets, and the loan agreement has to be payable on demand. Otherwise, the IRS sets the applicable federal rate, or AFR, for loans monthly. Charge less than the AFR and there can be gift tax implications, but again it’s pretty hard to violate the rules with a loan payable on demand for less than $10,000.
In your case with a $4,000 family loan, I’d still suggest charging the couple interest. They’re tying up your funds over time, and there’s a cost to you for the lost use of your savings over the loan term. The applicable federal rate in today’s interest rate environment is so low that I’d recommend just using the AFR for the loan.
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