Family loans are loans between relatives and family members. For some, borrowing money from a relative is a better option than taking a loan from a bank. With family loans, the borrower is not restricted to use the funds for a particular purpose, the rates and terms are typically better, and since family members know you, they’re usually easier to get.
Family Loans vs. Traditional Loans
A family loan is a common type of startup business financing but is not a loan from a bank, credit union, online lender, or another third-party creditor. Usually, family loans make a good deal for both the lender and the borrower because they not only help a relative out, but the interest income goes to a family member rather than to a bank or other lender.
Since a family loan is a flexible agreement between one or more family members, it’s important to know the differences when compared to a more traditional loan. Only then will you be able to identify and ask the right family members for a loan. A family loan is different than other types of loans based on the following:
1. Application Process
Often, the application process for a family loan is less complicated when compared to applying for a bank loan or borrowing from other lenders. Family loans are somewhat informal and do not usually involve a great deal of documentation like application forms and credit and background checks. The only document is typically a legal promissory note outlining the terms. Traditional loans, on the other hand, typically involves a lengthy, formal, and step-by-step application process.
2. Qualification Requirements
In most cases, family members don’t do an in-depth check of your qualifications. Usually, family lenders will decide whether they will lend you money based on your reputation in the family and your close social circle. Depending on the amount you request from a family member or members, the lender may or may not require collateral to secure the loan.
With banks and other creditors, however, the loan qualification requirements vary greatly depending on the type of loan. Aside from a minimum personal credit score, conventional and third party lenders also require typically require proof that you have the capacity to repay the loan, a cosigner, collateral, and other important requirements to establish your identity, creditworthiness, financial capability.
3. Interest Rates
Most family lenders are technically private lenders but they’re usually not loan sharks, and you can most likely negotiate good rates with them. Most relatives will typically agree to charge you IRS minimum rates, which range between 1.27% – 3.25%. This is way better compared to bank loan rates of 5% – 8% and alternative business financing like a Kabbage or OnDeck capital loan, which have average rates around 40%.
4. Other Costs
Most lenders typically charge origination fees and sometimes closing costs, which combined can easily run between 2% – 5%. With a loan from family members, however, these costs are completely negotiable and are often not included. There’s really no additional costs involved outside of the interest rate and legal payment for drawing up the promissory note.
When it comes to terms and conditions of a loan, traditional bank and other third party lenders are typically more stringent and have set loan lengths and repayment terms. With a loan from family members, however, the terms are almost always negotiable, and you can most likely come to a favorable loan length and repayment term. It’s common for family loans to be short-term, but it’s completely up to you and the family member or members giving you the loan.
How to Ask a Family Member for a Loan
Although the process of “applying” for a family member loan is less complicated than a traditional loan, there are important things that you need to consider when identifying and asking the right family members. This requires a lot of open, honest conversation and strategic planning.
Below are important tips to think about when identifying and asking family members for a loan:
- Draft a budget and/or business plan to figure out how much you really need to borrow and determine how quickly you can repay the principal and interest.
- Identify one or more family members who have the means to loan you the amount you need
- Ensure that you have a close and/or positive relationship with the relatives you ask for a loan.
- Understand IRS minimum interest rates and offer these rates to your family members.
- When you speak with these family members, be open about why you need money. It will be easier for your relatives to make a decision if they understand your needs.
- Be realistic with them about how long it will take for you to repay the loan. It doesn’t help to promise a quick repayment period if you know you can’t. This might get you the loan but will cause strife down the road.
- For the comfort of both parties, once you come to an agreement, put everything in writing. Treat this as a loan from a bank. Include the agreed interest rates, repayment terms, and your arrangement in case of default.
Tax Laws on Family Loans
Even if a loan is from a family member, the IRS still wants you to follow some guidelines. Although lenders are allowed to charge low interest rates, it’s important that the rates are in compliance with the Applicable Federal Rates (AFR).
Ideally, the terms and agreement should be put in writing and secured with a lien to satisfy IRS requirements like deductibility of interest. This makes it possible for you to deduct your interest payments and helps ensure that the family member or members claim their interest income on their tax returns.
Pros and Cons of Taking a Loan from a Family Member
Sometimes asking a family member for a loan is more difficult than asking a bank or third-party lenders. This is because people who are close to each other often feel awkward when it comes to financial matters. Because of this, the decision to ask a relative for a loan isn’t always the best option, despite its many advantages when compared to a traditional loan.
Pros of a Family Loan:
- Interest rates and terms are more easily negotiable.
- No need to submit a lengthy application or worry about specific requirements.
- You can get a loan with little to no fees, other than the interest rates.
Cons of a Family Loan:
- Loan services may be too complicated to handle and your relative may need to hire a third-party that will report to credit bureaus and handle taxes.
- This transaction may affect your relationship with your family, especially if something goes wrong.
- The family members who lend you money may feel that they have the right to dictate how you manage your personal finances or how you run your business.
Taking a loan from a family member may be a simple and easy option, but it’s not always the best option. It is important to consider your relationship first and foremost, and if you do take a loan from a family member, it’s important that you treat this loan like any other loan. For example, make sure the loan complies with the IRS regulatory requirements.