Have you ever been in a financial situation that made you think about borrowing money from a friend or family member? Maybe you needed cash because your car broke down, or you needed to cover tuition for a child. You probably thought it would be easier to work with someone from your inner circle as opposed to a bank.
But is it?
Borrowing money and negotiating repayment terms with a loved one doesn’t always work out as planned. In fact, more than a third of Americans said they lost money after lending cash to a friend or family member. Whether you need money to start up a small business or just to get through a tough time, before borrowing money from friends and family, here are some things to consider:
Why do you need to borrow money?
There are several reasons you might look to someone you trust to help you out financially, but before you ask for support, take one more look at what you can do on your own.
If you are experiencing true hardship, like job loss or overwhelming medical bills, there are actions you can take. For example, if you are unemployed, make sure you sign up for unemployment benefits the second you lose your job. The CARES Act has implemented an additional cash payout of $600 per week until July 31 and a second stimulus package may be on the way. If you have a medical emergency, many healthcare providers and lenders are offering flexibility during the pandemic, so contact them if you need help.
Or, maybe your problem is growing credit card debt. You could create a budget that helps you make plan to pay it off and to reduce expenses, even if it’s just temporarily. If all of your solutions have been exhausted, then it’s time to weigh the pros and cons of borrowing from someone who is close to you.
Pros of borrowing from friends and family
Receiving financial support from family or friends is common, especially among young adults, according to the Federal Reserve. Since it is so common, some people find positive outcomes after borrowing from friends and family, such as:
- Trust is already established. An existing relationship means they know and trust you.
- More negotiation flexibility. Together, you and your friend or loved one can decide on a minimum payment that works best for your budget and how long it will take to repay the loan.
- The interest rate could be lower. Your loved one might offer a lower interest rate or no interest rate at all.
- Your credit score is not impacted. In some cases, borrowing from a family member or friend could help shore up your credit score. A bank would be required to report a late loan payment to the credit bureau. A family member is not under the same obligation.
- Easier than borrowing from a bank. A financial institution may deny your loan application if you have had financial trouble in the past, and of course, mom and dad will probably ask for less paperwork than Wells Fargo would.
Cons of borrowing from friends and family
Though it could be easier to borrow from a loved one, than from a bank, there are may be unseen consequences. The biggest negative impact is that it can tarnish your relationship if you don’t pay the money back. Here are some ways that can happen:
- Expectations can go unmet. If you don’t lay out how you’ll repay the loan and then meet those requirements, you will be letting down someone you care about, both emotionally, and financially.
- Negative feelings can come up. You may experience guilt, shame, and embarrassment by asking for a helping hand. The lender may have feelings of anger if they think you are taking advantage of them if you don’t pay as promised.
- Changes the dynamic of your relationship. Once you owe money to someone who’s close to you, they may now have the upper hand in your relationship.
What to do if you borrow money from friends or family
If the benefits of borrowing money from a loved one outweigh the negatives, it’s important to have a plan in place before you borrow. You don’t want to enter into an agreement without laying some ground rules.
Get it in writing
Always put the repayment terms in writing. Doing this will keep both parties accountable and set expectations. If there isn’t a written agreement, then you open yourself to miscommunication and possible legal trouble.
Track your payment history
It’s a good idea to keep track of payments. You could use a spreadsheet or digital document with a log of the date you submitted payment, how much it was for, and the remaining balance. The document should be shared by both parties for extra transparency.
Offer to pay interest and late fees
To show that you are serious about this financial agreement, offer to pay interest and late fees if you miss a payment. This can show your loved one that you don’t want to take advantage of them and are committed to paying them back.
Make sure to consider taxes
If you end up borrowing money interest-free or less than the applicable federal rate (AFR) that is set by the IRS, both you and the lender could have income and gift tax consequences. That’s because the IRS may view an interest-free or low interest loan as a gift.
One way to address this is to have the lender charge you an interest rate equal to the AFR. Then when you go to file your taxes, you might be able to deduct the interest paid on your return depending on how the loan money was used. Finally, to avoid tax implications, you can borrow $10,000 or less. If the amount is under $10,000, you generally won’t have to worry about taxes between you and the lender. Talk to a tax attorney to make sure you understand the tax consequences of your specific loan amount.
Other ways to borrow money
There are other ways to borrow money that don’t all involve a traditional single-signer bank loan. Here are a three of the more well-known ways to borrow:
Through microlending, individuals or groups of individuals offer small amounts of money to people who need help starting a small business. If you are an entrepreneur or want to fund a business, microlending could be an option.
You can fund anything from covering medical treatments to paying off student loan debt through crowdfunding. Crowdfunding is particularly appealing because the funds are donated — which means you don’t have to pay anyone back. The key here is to address the purpose and benefit of donating in order to encourage people to open up their wallets and be truly transparent with your “lenders”.
If you specifically need to borrow money to rent an apartment or purchase a vehicle, co-signing could be an option. A co-signer is someone who signs a loan with the borrower. This helps the lender take on less risk if you can’t repay your loan, and in turn, they’ll look to the co-signer as a repayment source. A Bankrate survey found 21% of Americans cosigned a loan and as a result, 18% of them lost money, so make sure you have an agreement with your co-signer in place.
Break the borrowing cycle
If you have the habit of borrowing money from friends and family often, it might be time to take a step back and learn how to better deal with debt, money, and how to plan your financial future. To help you get started, download our free How to Manage Debt guide. It’s designed to help you better manage your debt and find the tools you need to move to a better financial future.
- How to Ask Creditors for Loan and Credit Card Forbearance (Freedom Debt Relief)
- Pros and Cons of Applying for a Personal Loan During COVID-19 (Freedom Debt Relief)
- Short on Cash? Here’s Some Advice For Families Stretching Their Budgets (NPR)
- It Pays to Tread Carefully When Lending Money to Family and Friends (CNBC)