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Family Loan Agreement Template

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The family loan agreement is a document that is made between relation by blood or marriage with one (1) acting as borrower and the other a lender. The family member that is asking for the money may be required to pay an interest rate, defined as a percent compounded annually, by the lending party. If so, the lender will be paid back more money than what was originally lent to the borrower. Although, usually funds loaned between family members are not charged an interest rate but depends on the family relationship.

How Does a Family Loan Agreement Work?

A family loan agreement shares the same basic elements with other lending contracts. It should specify a repayment term and payment schedule, an interest rate, and other contingencies, such as how late payments or a default will be handled.

Like any other legal contract, this agreement should include full names and addresses for both parties – and specify their relationship – and should be dated, signed, and witnessed by at least two others. Notarizing your agreement is also a good bet.

Interest Rate on a Family Loan

While there is clear wisdom in setting a repayment schedule, the idea of taking interest from a relative clashes with the very familial impulse that may have motivated the loan in the first place. Doesn’t family exist outside of the domains of the marketplace, capitalism, and profit?

Somewhat surprisingly, interest on family loans may be best thought of as a necessary evil.

First, there’s the issue of fairness: by advancing a sum of money to another person, the lender-family member is forgoing potential interest earnings. This is the opportunity cost of making a loan. Charging interest offsets this loss.

How much potential income is lost by making a loan to a family member? While current bank interest rates are near historic lows, the somewhat-riskier stock market has yielded big returns for investors large and small. What’s more? Investing in the markets is often less risky than extending credit to a son or cousin. Though you may not recoup all foregone investment income, charging some interest is fair.

The more critical issue involves taxes. If you make an interest-free loan above the IRS gift threshold – currently set at $14,000 – you will incur tax liabilities. Setting an interest rate above the modest “Applicable Federal Rate” or AFR that is dictated by the government prevents this.

Though states also set statutory maximums on interest that can be charged on loans, these anti-usury limits are irrelevant in most family-lending situations.

Things to Consider When Borrowing from Family

Often, borrowers turn to family after being refused by traditional lenders. This means that they are on shaky financial ground, with some combination of spotty credit and insufficient earnings. Though family loans are often used for pragmatic, and even edifying purposes – to finance education, consolidate debt, or purchase a first home – it is important to remember that abstaining from the formal credit system can reinforce existing credit issues. Since a family loan often occurs off-the-books of the formal financial system, the good faith process of regular repayment does not build the borrower’s credit history as it would with an official loan.

As a compromise solution, family can enlist the support of a third-party processor to facilitate repayment and report results to the credit bureaus. There are several competing online services, including the popular Loanback.com.

Family Lending vs. Bank Lending

Though taking a formal loan can mean being subjected to considerable vetting, borrowing from family is not necessarily any simpler. Often, the choice to take a family loan means trading one kind of complication for another. You do not have to worry about hurting the bank’s feelings or alienating its loan officers – but the same can certainly not be said for a family loan.

In general, the best course is to imitate the formal process, absent the administrative layers that can prolong and complicate bank transactions. Though borrowing from a family member may be the only option for less-creditworthy borrows, the end goal is usually to repair credit and finances so that future borrowing occurs in the formal sector. While family finance may be a good stop-gap solution, it is unlikely to be the best long-term solution.