Family finance: Be cautious when lending money to relative

Get it in writing.

That's the No. 1 recommendation from financial professionals about lending money to a relative.

Yet as more people who are unemployed or face losing their homes seek help, most people who make loans to family members skip that important step. The result is family loans often don't get paid back, and hard feelings can damage relationships.

"There's an old saying with a family loan," said Donald W. Patrick, a certified financial planner with Patrick, MacLeod & Cranman in Atlanta. "Consider it a gift."

It doesn't have to be that way.

Documenting a loan can be done simply and at low cost. Spelling out the terms makes the arrangement businesslike, and can help avoid emotional and financial issues that may arise if the money isn't repaid.

"If everybody put everything in writing, it would work more often," said Mitchell Kraus, a certified financial planner with Capital Intelligence Associates, Los Angeles.

Some people think that a formal agreement isn't needed if the loan is between close relatives. But whether the borrower is your child or a third cousin twice-removed, professionals warn against depending on trust alone. And try to keep emotions out of it.

Advisers also counsel not to lend money you can't afford to give away. Older parents frequently use savings they need for future living expenses to lend to their kids.

"We see the emotion when the kids aren't paying back and the parents are really feeling a financial pinch," said Sally Hurme of AARP.

Reasons to lend

Unemployment is at 10 percent, and 35 percent of Americans say the financial situation in their households is "poor," a recent Associated Press-GfK poll found. Home foreclosures remain epidemic and banks are still tight with lending.

"There's no doubt about it. It's bad out there," said Patrick. His clients, who tend to be wealthy, are reporting more requests for loans from family, usually their children. Planners say the reasons for the requests run the gamut from debt consolidation to medical expenses to preventing foreclosure.

And if the family lender charges interest, the loan could be more profitable than putting the money in a certificate of deposit or even many bonds.

Deborah Danielson, owner of Danielson Financial Group in Las Vegas, has clients who financed a $140,000 mortgage for their son. They are charging just 4 percent interest - lower than he would have gotten at any bank, yet more than the money was earning parked in CDs.

To structure it as a business arrangement, the couple had a mortgage company draw up the documents and hire a company to collect the payments. Their son sends his payment to the collector, along with a $6 fee for processing. At year end, the company will send statements to both parties for tax purposes.

Danielson said the arrangement made everyone more comfortable, since the son is dealing with a company instead of writing a check to his parents.

How to set up a loan

The loan documentation, at the very least, should state the amount, duration, interest rate, payment size, and any late penalties. It may seem like overkill, but making the terms clear ensures that everyone knows what is expected.

"If you don't pay your mortgage or you don't pay your MasterCard, they penalize you or they take your credit away," said Stuart Rohatiner, senior tax manager with Gerson, Preston, Robinson & Co., a Miami accounting firm. "With a parent or a relative, there's too much emotion involved."

There can be tax implications for loans among family members if no interest is charged, or if the interest rate is very low. Typically, the Internal Revenue Service expects lenders to charge the "applicable federal rate," published monthly by the agency. The rates also vary with the length of the loan: currently a loan of three to nine years, for example, must carry a rate of at least 2.61 percent.

If no interest is charged, the loan could be considered a gift. In that case, the lender would have to pay gift tax on any amount over $13,000.

Prepared lending forms are available at some office supply stores and online. Forms can also be found at LendingKarma.com, where users can set up e-mail payment reminders for borrowers. Payments can also be entered and tracked on the site.

Some peer-to-peer lending sites, like VirginMoney.com and Prosper.com, facilitate the loan, acting as a middleman between lender and borrower to collect and distribute payments.

More complicated or large loans may best be handled by a financial planner or an attorney. For mortgages, it's smart to run a credit check and to verify income like a bank would, said Dale Siegel, an attorney with Circle Mortgage Group in Harrison, N.Y. and author of "The New Rules for Mortgages." ''From step one, after everybody understands how this is going to work."

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