We are living in interesting times. Several Edwards Group clients have expressed uncertainty about how to safely invest their money given these unprecedented low-interest rates. Certificates of deposit have long been a favorite for risk-averse investors, but in this economic climate a mason jar in the backyard may produce the same results. One possible solution could be intra-family lending.
Some of us would never dream of lending money to family members, as it could lead to misunderstandings and strained relationships. If something goes wrong, it could put your family at risk for conflict. However, some families can benefit from intra-family lending while managing the emotional stakes.
A Win-Win Scenario: The Potential Benefits of Intra-Family Lending
Setting aside the emotional and relational risk, intra-family lending can offer helpful opportunities for multiple generations:
- Older investors may be looking for a safe investment that yields 1- 3%.
- Mature children may be refinancing a home or paying off student loans for their children, with rates in the 4-8% range.
- There may be a third generation with substantial student loans at a rate of 7-8%.
What if adult children saddled with high-cost loans could refinance them at 3% with their parents or grandparents? This would provide a stable investment yield of 3% for the older generation and would benefit both members of the family.
Intra-Family Lending Can Go Terribly Wrong When the Motive is Rescuing the Borrower
Outside of family lending, contracts between borrowers and lenders work because there is a benefit for both sides. In a family, however, if one party offers a loan to help or “rescue” a family member who is struggling financially, the results can be problematic, if not disastrous. Therefore, it is very important to note that a family loan is not a loan to get someone out of trouble. Intra-family lending is a privilege that you offer within your family, and must provide a benefit to both parties.
Many believe that family borrowing is riskier for the lender than the borrower, but it doesn’t have to be this way. Often when we hear about family lending gone bad, the borrower was in trouble and the family loan was offered to bail them out. But when done properly, the borrower is financially responsible and poses low risk to the lender. When considering intra-family lending, there are some hard questions that need to be asked to determine if this is a good idea for your family:
- Can your risk-averse investor afford to take a risk on the family? Maybe more importantly, would a bank be willing to take a risk on your family member?
- As a borrower, can you handle the additional responsibility you have to the family?
Family lending is not for everyone; this is a solution for mature lenders and responsible borrowers.
Best Practices for Intra-Family Lending
Here are some best practices to consider:
- Only lend to family members who are beneficiaries of your estate. This strategy creates more ownership in the loan and allows the borrower to feel like they contribute to the family inheritance. If a distant relative wants to borrow money but does not directly benefit from the estate, this is probably not an acceptable risk. Lending works best if the borrower realizes it helps grow the family inheritance or secure more of their future and yours. If they default on the loan, they are putting the estate at risk.
- If the borrower is an acceptable risk for the bank, they will probably be an acceptable risk for the family.
- Intra-family lending is not for bailout loans.
- If the lender dies before pay-off, be sure to document the amount and deduct it from the borrower’s inheritance.
- If this is a mortgage loan, the borrower can still deduct the interest from their taxes. The lender will need to provide a document showing the amount of interest paid during that year.
If, after reading the above, you think this might be a good option for your family, here are some more things to think through depending on whether you’re the borrower or the lender…
- Do you have enough capital to invest in your family member’s needs for a set amount of time? It is crucial not to recall the loan in emergencies. Do not leave yourself short.
- Set a ceiling for money allowed to borrow.
- Also, determine the types of loans you will approve. Paying off student debt, second mortgages, or cars.
- A family loan is not a bailout program. Credit card repayment is not a good option.
- Choose guidelines to put in place in order to determine whether they are a reasonable risk, such as history of payment or credit score.
- Establish the terms of the loan ahead of time. Do you want collateral? What interest rate will you charge? What will the length of loan be?
- When establishing the terms of the loan, pay careful attention to how you will handle a late payment or a missed payment.
- Create a contract.
- Choose loans that have high interest rates, such as student loans, car loans, or second mortgages.
- Choose loans that have a five to ten year commitment remaining. Extended periods beyond ten years can put the family at risk, because situations and needs may change in that time.
- Request regular loan statements for accounting purposes.
- Repay your loan on time. Do not consider these loans as the last bills you pay. Do not put your family lender in a position to have a difficult conversation.
5 Items That Won’t Be in Your Loan Contract, But Should Be Considered
• Pride – You may have to swallow yours. Think about these loans as a way to invest in the family. You are helping grow the family inheritance by paying into it yourself through these loans.
• Honor – Honor the agreement and the payment structure. Do not put family members in a position to have a difficult conversation with you.
• Transparency – Being secretive with family members will likely hurt others’ feelings, while transparency will help with accountability. Include other family members to help make decisions and keep each other accountable.
• Gratitude – Appreciate what you are doing for one another, both the lender and the borrower.
• Celebrate – This is a time to celebrate that you can take care of each other’s needs, as a family, and everyone wins!
National Family Mortgage has some great information on their website, and their resources can make intra-family lending more official, as well as provide extra protection. As always, we at Edwards Group are available to talk with you and answer your questions. Feel free to reach out to us at 217-726-9200.