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Your Bank > Education and Advice > CNB University

What's on the horizon for 2010?

James P. Terwilliger
James P. Terwilliger, PhD, CFP® is Senior Vice President - Group Manager, Financial Planning Strategies and can be reached at JTerwilliger@CNBank.com or (585) 419-0670 x50630.

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 and lender.

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 about money.

Like everything else, there are pros and cons.

Pros

  • 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 business plan).
  • 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 small-business loan.
  • 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.

Cons

  • 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 favorable.
  • 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 the transaction.

Please note that my summary does not replace the need to consult with an attorney, tax professional and/or other financial professional.

WSG Team