Edward Jastrem is a certified financial planner and the director of financial planning at Heritage Financial in Westwood, Massachusetts.
Some may consider a loan from mom or dad as a financing choice of last resort. That’s not surprising, as mixing family and money can create stress or anxiety.
But as more young adults rely on their parents financially for longer, it could ease tensions if the children consider an intrafamily loan instead of taking handouts. But it may take some convincing to alleviate their parents’ concerns around such an arrangement.
Take these steps to reduce tension surrounding a loan conversation and to show that a family loan could benefit both you and your parents.
Conduct due diligence and self-reflection
Your parents may want to know that you’ve already explored other options before coming to them. In addition to traditional bank loans, evaluate peer-to-peer and non-traditional bank platforms such as Upstart, LendingClub, and SoFi.
Looking at various borrowing options demonstrates your sincerity in the process. If you have poor credit or limited savings, be prepared to address what you have done to make improvements or how the family loan is a step in improving your financial fitness.
Make it a fair deal
In most cases, a parent’s decision to lend money to their children will not be motivated by profit. Still, that doesn’t mean parents shouldn’t be compensated for their assistance.
Repaying your loan with interest helps validate the contract. If your parents work with a financial advisor, the advisor may recommend an interest rate based on your parents’ opportunity cost, or a minimum IRS rate known as the applicable federal rate, or AFR.
Don’t confuse a loan for a gift
It’s not uncommon for family to forgive a loan — as a graduation or wedding present, for example. What’s important is to start the intrafamily loan process with clear expectations.
If the borrower assumes they won’t be on the hook for repayment and it turns out otherwise, everyone will be disappointed. It’s best to avoid starting any loans if successful repayment depends on the generosity of others.
Put it in writing
It’s in everyone’s best interest to get the terms in writing. This may seem overly formal with family, but it helps clarify what was agreed upon for both your parent as the lender and you as the borrower.
An agreement should name the parties involved as well as the amount, length, and interest cost of the loan. Consider if any fees would apply to late payments, and how the payment should be made – such as electronic bank transfer.
Depending on the size and perceived risk of the loan, your parents may want to consult with an attorney. Other details may include what recourse your parents have — such as securing collateral — if you default. For those comfortable doing it themselves, online resources and public libraries have materials for example promissory notes with standard terms.
Good record-keeping habits should be exercised with any financial obligation. A recurring calendar reminder is one way to keep payments on schedule. You may need to share details of the loan with a tax preparer or other professional adviser. Create a file or binder to easily access all your loan records.
Plan for contingencies
If your parents are financially healthy enough to weather a delinquency or default, they may not need to dwell too much on the impact of your premature death or disability.
However, if you want to provide more reassurance for repayment, these types of contingencies can be added in your promissory note. For instance, you could name your parents as the beneficiary of a life insurance policy or retirement plan while the loan is outstanding. If you have a family of your own, you may need to take extra time to plan for the unexpected.
Watch out for legal and tax issues
When signing your loan agreement, it’s critical that you and your parents understand the terms and have the ability to execute a contract. Consider having the contract signed by a witness and notarized to provide some additional backing to its legitimacy.
Depending on the size of the loan, your parents may need to consider its impact on their estate plan and other aspects of their total finances. The exact treatment of interest may depend on how the loan proceeds were used and if a loan and gift were combined.
If the loan is going to be treated as a mortgage on a home, a recorded lien may be needed with the registry of deeds. You and your parents both should talk to tax professionals about the interest paid and received on the loan and how to account for it on your respective tax returns.
Intrafamily loans aren’t right for all situations. But when implemented thoughtfully and carefully, they can serve as a valuable financial tool.
Read more information and tips in our Family section