Personal lending is seeing a resurgence these days, given the
downturn in the economy, job losses and the tightening of commercial
credit underwriting requirements.
Most often, such transactions are between family members or
friends and generally viewed as a win-win for both the borrower
Not so fast: The transaction can be a win-win if done with
the proper care. When it's not, the results can be disastrous.
Few things in life can drive a wedge between family members
or between friends as quickly and as easily as a dispute
Like everything else, there are pros and cons.
- A personal loan can provide the borrower with a
more favorable interest rate or pay-back schedule versus
what is available in the commercial market, while
at the same time provide the lender with an above-market
return on the investment - truly a win-win.
- The borrower may need to provide little or no
collateral or minimal documentation (i.e., formal
- For intra-family transactions, a personal loan
keeps the money within the family.
- It can enable a loan to a borrower whose credit otherwise
would prohibit access to a commercial loan.
- If structured properly, it can provide tax-deduction benefits
to the borrower in the case of a home mortgage, home equity, or
- It can provide an additional equity injection into a small
business that already has maxed out a commercial loan limit.
- It can offer a potentially quicker turnaround time.
- If designed with a balloon payment, it can keep payments
low while giving a borrower more time to find permanent financing.
- Loan agreements that are not well-documented and specific
with regard to interest rate, timeframe and payment schedule are
potential recipes for disaster. Proper documentation is critical to
ensure both parties understand their respective responsibilities.
- The same is true in the event of the untimely death of either
the borrower or lender. Death of the borrower does not negate the
responsibility of the borrower's estate to repay the lender. Alternatively,
the death of the lender does not negate the responsibility
of the borrower to the lender's estate. Undocumented loans
are difficult, if not impossible, to enforce.
- For loans between family members, friction can arise
from other jealous relatives, particularly if the terms are
- Unmet loan terms, even if temporary, can strain relationships.
Needless to say, formal legal documentation is essential.
Loan agreements need to be properly constructed
with signatures notarized.
If the loan is secured by real property, the mortgage
should ideally be recorded in the appropriate county
clerk's office, where a recording fee and mortgage tax
would be charged.
Similarly, if a security interest is taken in personal
property, the interest should be perfected by filing.
Parties are best served by working with professionals
who can include a financial planner (providing advice
about the impacts a loan might have on their financial
situations), a CPA or other tax professional (providing
advice about how to structure the loan properly for tax
purposes) and an attorney (to draft the agreement and
any associated promissory note). Depending on the situation
and relationship between the parties, each might
want to consult a separate team of advisors.
Often overlooked in private-loan agreements is the need to
include language describing what happens if either the borrower
or lender must alter or terminate the agreement, or if the borrower
wishes to prepay or delay payment. Fortunately, with personal
loans between parties who have had a long-term healthy
relationship, such terms often are or can be quite favorable.
Surprising to many folks, too, is that the interest rate on these
loans cannot just be picked out of the air. The IRS has guidelines,
and failure to follow them can result in negative tax consequences.
Interest rates are updated regularly at
www.irs.gov/app/picklist/list/federalRates.html . Also, the lender
needs to understand that the interest component of the loan
repayment generally is taxable.
Further, a partial or full forgiveness of a loan, which more often
occurs with intra-family transactions, needs to conform to the
annual gift tax exclusion rules. Currently, each person's limit is
$13,000 per year per recipient. In cases where, for instance, a
couple makes a loan to a child and his or her spouse, the annual
limit is four times that figure or $52,000 per year.
Finally, we're back to where we started: The distinguishing
and most-important feature of a personal loan is the relationship.
It is not the money. The parties should make preservation of the
relationship their first priority when considering and implementing
Please note that my summary does not replace the need to consult
with an attorney, tax professional and/or other financial professional.