October, 2007
Thinking About Borrowing from Family or Friends? Do It The Right Way.
Whether it’s for a business, a home, or a new car, when people get a loan from family and friends, nobody’s worried about a credit check or lengthy documentation – and you can hang out with your lenders during the holidays.
In 2005, the National Association of Realtors reported that about 9 percent of first-time homebuyers made their purchase with help from a friend or relative, up from 5 percent in 1999. About 25 percent of new homebuyers get money from a relative or friend, a statistic that’s remained fairly constant over the past decade.
Yet there are good and bad aspects to private loans. First. the good news:
• Terms can be significantly friendlier than a borrower would qualify for in the open market. For example, the rate charged on the loan can be higher than the lender would receive in a deposit account but lower than the borrower would pay a commercial lender.
• The loans may require little or no collateral.
• It’s a way to keep money in the family.
• It’s a way for a borrower to be able to buy a home, a car or other critical assets, even with a poor credit rating.
• There’s no loss of tax benefits to the borrower or lender if the agreement is structured and reported properly.
But then there’s the bad news:
• Unclear agreements can lead to missed payments or default.
• If the borrower dies suddenly, the lender’s investment may be lost if the agreement isn’t structured correctly. A properly executed promissory note is still an obligation of the estate, and may continue to be paid to an heir or other person or entity based on the terms as agreed.
• Jealous relatives may say that they weren’t treated fairly.
• Disagreements between borrower and lender could damage an important relationship.
The best arrangements are formal – written in proper legal language, notarized and recorded in the county where the property resides. A financial adviser can talk to both parties about what such loans – particularly real estate loans – can mean for their respective finances. It also makes sense for both parties to visit their respective tax professionals to make sure they know the correct ways to document the loan transaction over time for tax purposes.
A detailed document – prepared with the help of an attorney – can also lay out specific scenarios if either the borrower or the lender has to break or alter the agreement. Such trained experts can talk you through the benefits and pitfalls of a private loan arrangement as it affects your particular situation (either as lender or borrower). They can also explain specific laws and requirements that you must follow so that both borrower and lender can derive tax advantages from the agreement.
Generally, any private loan transaction should include a promissory note that establishes how the debt will be repaid. That’s true for business loans or loans for most types of property. In the case of a business loan, it makes sense for the potential borrower to get specific advice on how lenders in their business will be treated not only in terms of repayment, but default.
In the case of a loan made for real estate, a mortgage or “deed of trust†statement (depending on the state you live in) or an agreement specific to the type of loan that binds the property as collateral for the promissory note will be necessary. Such a document basically says that if you don’t fulfill all the terms in the agreement, the lender has the right to foreclose or repossess the property.
Even if a friend or relative makes an offer of help, it’s proper for the borrower to take the initiative to structure the arrangement in a way that’s responsible and beneficial to both. If a relative is drawing income from the loan, special provisions should be made for prepayment and other contingencies.
What’s the most important thing to remember and plan for? When two people who are close enter into such an arrangement, the most valuable thing isn’t the money, it’s the relationship.
October 2007 This column is produced by the Financial Planning Association, the membership organization for the financial planning community. It has been modified and is provided by Thomas A. Fisher, a local member of the FPA.
The material presented is believed to be from reliable sources and we make no representations as to its accuracy or completeness. All information and ideas should be discussed in detail with your own adviser prior to implementation in order to determine whether the strategies mentioned are appropriate for your specific situation.