There are some who will tell you that family loans are just a bad idea all around. However, it is really a matter of the particular family and what is expected. For example, in my own family, loans are expected to be repaid – period. Because of this it is not a big deal to bring up a late payment or other issues. Interest is charged and usually at a rate which at least replaces the income that would have been made if the money stayed in the bank.
On the other hand, there are families that consider it rude to expect or talk about repayment of a loan, or to charge interest. In these cases, why call it a loan if it is clearly a gift? In fact, even if it is repaid, but without interest, it is a gift of the interest lost (or what the borrower would have normally paid a bank). This kind of dishonesty generates bad feelings. If a gift is asked for, call it that.
Apart from the nasty relationship problems that can arise from family loans, there are the tax issues to consider. If you loan larger amounts, like the money for a down payment or to buy a car, the Internal revenue Service will likely assume an “imputed interest” rate, even if the loan is interest free. .In other words, you may get the money back, but in the meantime pay taxes on the assumed interest collected. If you prepare and efile taxes yourself, make sure to talk to a tax preparer or accountant about this.
Cosigning a Loan
Some parents or brothers or sisters help their children or siblings by way of “loaning” their good credit in the form of cosigning on a loan. Is that a good idea? Almost never. A son or sister or daughter or brother only needs you to cosign because a bank has determined he or she is too risky to loan money to. Lenders are better than you at determining these things than you – really.
In addition to the credit risk of cosigning, which I’ll get into in more detail in a moment, there is the real risk that you won’t actually help your loved one. For example, more often than not, when parents help a child by cosigning on a car loan they just help him or her into a debt that may last beyond the life of the automobile. Debt for consumer items is a bad habit that we shouldn’t help others develop. “Helping” friends and family into more stress and trouble is all too common.
What about your credit rating risk? When you cosign a loan you are legally obligated to to pay if the borrower defaults. That much you probably understand, but you may not know that in many states the law doesn’t require creditors to notify a cosigner if the borrower is late on payments. In that case you not only become liable for the debt, but you also get a black mark on your credit report before you even know there is a default or late payment.
Assuming there is a good reason to help a family member, here are three safer ways to use instead of cosigning a loan:
1. Put up collateral for a loan.
Deposit the amount of the loan in an interest-bearing account and let the borrower use it as collateral for a loan if your bank or theirs permits this. Of course you’ll lose the money if your family member doesn’t make the payments – you’re on the hook for the whole amount if you cosign anyhow. But this way your credit rating won’t be affected, since your name won’t be on the loan.
2. Lend the money yourself.
Assuming you can afford to lose the money (and if you can’t, why would you ever consider cosigning a loan?) just lend the money yourself. But charge a reasonable interest rate to make up what you lose taking the money out of the bank.
3. Help them establish credit.
To help a son, daughter or other family member establish credit, put them on your credit card, or on a loan that is in your name. They get to build a credit history, but the monthly statements will come directly to you. That way if they are making the payments you’ll know if there is a problem.
With the right money beliefs and relationships family loans can be a great idea. They can help a person start a business, or pay for education or get proper medical care. Just keep it honest and sensible – and protect yourself.