Years after the great financial crisis we find ourselves in very interesting times. Many folks are holding more cash than they imagined they ever would. But when is a good time to put that money to work in the markets? Interest rates are at historic lows, and have been longer than most of us would have guessed. The market has rallied multiple times to all-time highs. And over the long term, we anticipate it will continue to go higher. But when is the pullback that we have all been waiting for going to arrive? The economy is getting stronger, but is still fragile at the same time. Bonds will lose value when rates rise, but when will that happen? How fast and how high will rates go? What other effective and (possibly equally as important) impactful places can you put your money to work? Enter, Family (Friend) Loans.
For some, this may be about getting more interest than in a bank account. For others, it may create an effective gifting mechanism for the kids to buy a home or consolidate debt. Wouldn’t it be nice to see your kid’s inheritance have an impact while you are still alive? (I will leave it up to you to insert your own reminders of mortality here).
Whether the topic of discussion is for loans to purchase a home, renovations, paying off student loans, wedding debt, etc., a Family (Friend) Loan may be a solution. Family and friends often can provide a loan on their own terms. This could mean lower interest rates and underwriting requirements than banks. And for those that want to commit substantial gifts to children, but want to hold the children accountable over time, this could be a solution. This year families can gift up to $14,000 without paying a gift tax (known as annual gift exclusion) in order to forgive some (or all) of the loans obligation over time.
Benefits to Borrowers
-Borrowers can avoid additional fees charged by traditional lenders and keep the profit in the family.
-The family member (friend) lending can offer better rates than banks
-Family members may offer more flexibility in paying back the loan.
-If properly documented, a mortgage on a home can still be tax deductible.
-The borrower can have the ability to negotiate the purchase price in terms of a cash offer vs. with mortgage contingency (a big plus in competitive housing markets like Boston).
Benefits to Lenders
-The loan can become a more conservative (or riskier, depending on the borrower) part of the investment portfolio for the family member.
-The borrower could offer a higher interest to lender than they are getting on some of the current investments (savings, CD’s, etc).
-The loan repayment could generate a steady income stream for the lender.
-The lender could provide funds to the borrower with strings attached. In other words, they can decide to gift (forgive) a portion of the loan in some years, but not others.
Considerations and Risks
With the ability to have “loose” or minimal lending requirements and standards between family or friends, this can be both a positive and a risk. As we typically advise clients, although you may get into a business venture with the best intentions in mind, it is prudent to think through the risks and protect yourself (within reason) when you can. My point is, what if you lend money and the payments stop coming? Or they are late? Are you okay with this? If not, what is the recourse? As the lender, you are in a position to structure the expectations up front and make concessions down the road (if you choose to). Maybe you require collateral. Maybe you charge late payment penalties. Maybe you hire an independent third party (at the borrowers expense) to administer and collect on the loan so you can keep the peace at Thanksgiving.
As the usual disclaimer goes, this strategy requires the collaboration of legal and tax counsel.
Resources These are not recommendations, but resources that we thought could be helpful.
To set the minimum interest rate for the loan, the AFR is published monthly by the IRS for federal income tax purposes at http://apps.irs.gov/app/picklist/list/federalRates.html.
Once the loan is agreed upon, it is good idea to draft and sign a loan agreement. Here is a Sample Loan agreement: (http://www.creditcards.com/credit-card-news/sample-promissory_note-friends-family-loans-1293.php)
Here is a company that handles all of the detail of the loan so that it is IRS compliant at a lower cost than a traditional mortgage loan. They can set up automatic drafts of debt payment.
National Family Mortgage https://www.nationalfamilymortgage.com/for-financial-advisors/
Here is a company that connects borrows to lenders without the middleman if you don’t want to turn to friends or family.