What to Consider Before Making a Loan to a Loved One
“My loved one is in debt and asked for my help in paying it off. What should I do?” At Creative Planning, we run into this question often, as family and finances are so frequently interconnected with one another. When it comes to deciding a course of action, oftentimes there’s not one clear and obvious answer. Before making a financial commitment to help a loved one, be sure to consider the following.
What are the alternatives?
Before volunteering your own funds, a positive first step is to understand if there are there any other ways to help your loved one clear up their debt. If it’s reached a point where it has destroyed your loved one’s credit rating, it could make sense to have it written off by declaring bankruptcy. Or perhaps you can help your loved one find a debt management program or pursue a debt settlement arrangement. Depending on the circumstances, there may be other ways to help your loved one gain financial footing that don’t require a check from you.
How will the money be used?
If alternatives fail to produce a viable solution, before committing your funds, it’s best to understand how the current or new debt may be impacting your loved one’s situation. As the potential lender, it’s natural to question the borrower’s previous financial decisions. Practically, you (as the lender) may not view paying off an auto loan as prudent; however, there may be more common ground around paying off an outstanding medical or educational debt. Having clarity regarding how the loan is to be used may help to overcome emotions and objections around providing a loan. Whether the loan helps to free one from their debt burden or enable a new venture, the purpose of the loan should be clearly defined. If servicing existing debt, it may be wise to ensure any money you lend is being used to pay off principal, which will have a greater impact on your loved one’s overall financial health.
What are the specific terms of the loan?
Just as you would with any other borrower, have your loved one agree to the loan’s terms in writing before you issue a check. While this may seem harsh, it’s an important step to help ensure there are no misunderstandings or resentments down the road. Your loan agreement should include the following:
- The amount you’re lending
- The timeframe in which the loan will be repaid
- Any agreed-upon interest, if applicable
- The amount and frequency of payments, if applicable
Keep in mind that loans over a certain threshold amount may be viewed by the IRS as taxable gifts if not repaid in full. One way to avoid tax liabilities is to charge interest and require regular payments.
What is the “repayment priority”?
Depending on your loved one’s financial situation, your loan may be just one part of their total “loan portfolio.” Even if you and your loved one agree on a payment plan, your payment schedule may not be as rigidly set as a traditional creditor’s may be. In other words, you may be more willing and able to allow for a payment to be missed while your loved one addresses their other obligations. Make sure you’re comfortable knowing that you may be at the bottom of your loved one’s obligation list and that, in the event they’re unable to pay you back, you’re also comfortable with potentially not receiving the loan back in full.
What is your level of comfort with lending?
If a loan to your loved one would put your financial future in jeopardy, it wouldn’t be a prudent decision to make the loan in the first place. If you’re in the position where you’re able to provide the loan without negatively impacting your financial future, then loaning a loved one money is less about your ability to “afford it” and more about your level of comfort in introducing a borrower/lender arrangement into your relationship. There can be many emotions evolved in mixing business and family. Regardless of any other considerations, if you’re not comfortable not seeing the money again, it may not be a good idea to loan it in the first place.
At Creative Planning, we understand how complex family relationships can impact your financial well-being. We’re here to help you navigate a wide range of financial challenges, including the decision of whether to loan money to a loved one. For more information, schedule a call with a member of our team.