There are times when lending one’s ear to a friend or family member going through a difficult time just isn’t enough. What they need the most is an infusion of cash. Should you or shouldn’t you reach into your pocket and help them out with a good-faith loan? While this intrepid financial planner cannot advise on relationship dynamics and how they might be detrimentally affected with a personal loan, I can tell you how to protect yourself if you do decide to go ahead with one.
Draw Up a Promissory Note
Despite everyone’s best intentions at the outset, a handshake is not enough to seal the deal. The best thing each party can do is protect themselves with a written contract called a promissory note. Basically, the promissory note is a document wherein the borrower promises to pay the lender back. It should state the loan amount, the interest charged, the repayment plan, the per diem for any late payments, and be signed by both parties. Once you have agreed on the interest rate, you can use an online calculator to calculate the amount of each payment over the term of the loan. Regarding repayment, you can arrange a lump sum payment (most common), an installment payment plan, or even a balloon payment plan (rare). Each party’s signature makes the promissory note an unbiased document that can be used as a gentle reminder, a means of exerting pressure, or evidence that will hold up in court (heaven forbid it comes to that).
Also, consider what would happen if you were to die before the loan is repaid. Depending on the amount loaned, you may want to add a line to the promissory note that stipulates that the borrower will either pay your estate back any amount still owed, or receive a decreased inheritance based on the amount still owed. This can protect other family members who will receive their inheritance out of your estate and prevent conflict between beneficiaries.
If there is serious concern about repayment, an added layer of protection would be to have the promissory note notarized, which would officially recognize the document and give you increased legal standing in court, although it is not necessary. However, if there is serious concern about repayment, perhaps the loan is not the best option anyway.
Charge a Favorable Rate
If you make a personal loan, the IRS requires you to charge a minimum interest rate, called the Applicable Federal Rate (AFR), to avoid potential income tax and gift tax consequences. The interest you collect is then reported as interest income on your tax return. The AFR is less than what borrowers would have to pay for a bank loan, but more than what lenders could earn from CDs or money market accounts. The AFR you must charge depends on the term of the loan:
Short-term (< 3 years)
Mid-term (3 – 9 years)
Long-term (9+ years)
What if it makes you feel Scrooge-like and ungenerous to charge the borrower interest? You might consider that the function of interest is to fairly compensate the lender for using money that could have been earning interest elsewhere. By lending that money to your borrower, you give up the opportunity cost. That said, you can still go ahead with an interest-free loan if that is most comfortable.
What happens then? If you make an interest-free loan and the IRS discovers it, they can impute the interest and require you to report it on your tax return. The uncharged interest can be treated as a tax-free gift to the borrower as long as it’s under the gift tax annual exclusion amount for the year (it’s $14,000 in 2016). Otherwise, any uncharged interest over the gift tax annual exclusion amount will need to be reported on your tax return. However, only a handful of people ever pay gift taxes in the end. This is because any amount over the gift tax annual exclusion amount reported on your tax return is added to your lifetime exclusion amount free of Federal estate tax (which is a whopping $5.34 million in 2016).
With the promissory note in place, let go of any attachment you might have to the borrower’s use of the money. You have made a careful effort to set up an agreement where you are the bank and this should free you (and the borrower) of any emotional tangles or obligations that belong outside of the loan agreement. Ideally, both parties can compartmentalize the loan and resume their normal relationship with one other.