Should You Lend Money to a Family Member?

I have six siblings and 30 cousins. So, believe me, I've been asked for a loan—many times. Since we're a two-income family with no kids, not even a pet, we're often able to help. And we want to. We have a heart for helping and giving, and not just through charitable donations, but also by helping individuals. For example, when some families in Arkansas lost their homes in a big storm, we were there for them. When my in-laws needed a loan to start a new business, we could invest in their goal. When a cousin needed a small loan to make it to the next paycheck, we could do it.

But we've learned from experience that some loans get paid back—and some don't. So, it's important to set expectations and limits right from the start.

Of course, that's not always easy. Family loans aren't just about money; they're about relationships. Things could get awkward and uncomfortable. But there are ways to loan a family member money without ruining your relationship. Here's what I suggest.

First, take a good look at your own finances: What can you afford to lend—and afford to lose? Some relatives won't pay you back, regardless of their good intentions. When we loaned money to my in-laws, we had to ask ourselves if we'd still be able to cover emergencies without going into debt ourselves if it wasn't paid back. We wanted to make sure lending the money wouldn't keep us from meeting our own goals if it wasn't returned. (Fortunately, it was!)

Bottom line? Make sure you can handle your own bills and that your emergency fund is in place. And never jeopardize your retirement savings to lend someone else money. Set personal limits, and don't feel guilty if you have to say no.

This is another relationship that can be affected when you lend money. Make sure you and your spouse or partner agree beforehand not only on making the loan but on the terms of repayment. No matter which family member you're lending to, if you share accounts, it will affect both of you in the short term and possibly in the future.

Some people are down on their luck, some are habitual borrowers, and some—like my in-laws—may come to you with a solid business plan. Think about who is asking you for a loan and why. If it's someone who you know has trouble managing their money, and you want to help them out, that's okay. Just be aware that they might not pay you back. If it's someone you're bailing out constantly, you may want to reconsider.

I confess I didn't always do this, but I wish I had. On a personal level, having a loan agreement in writing makes it much easier for everyone because you're clearly stating the terms up front, including interest charges and repayment schedule. But there are tax reasons to do this also.

To satisfy IRS requirements for a family loan, you must 1) have a signed written agreement, 2) require payment(s) based on a schedule, and 3) charge adequate interest (if the loan is more than $10,000). You don't have to charge market rates, but you must set an interest rate at least equal to what the IRS refers to as the "applicable federal rate" (AFR). This is especially important if the loan is over $10,000. Otherwise, the loan could be considered "below market" and could trigger gift and income tax consequences. AFR rates are set monthly and vary depending on the type and term of the loan. You can find them at irs.gov.  

Documentation also gives you the ability to deduct an unpaid loan on your income tax return if, for any reason, your borrower defaults on the loan. One more thing: Don't try to disguise a gift as a loan. That could also trip you up tax-wise. All this can be tricky, so check with a tax advisor if you're unsure about what to do.

Money is hard to talk about, but this is one time it's essential. Right up front, you and the borrower need to agree on the amount loaned, the interest rate, and whether the repayment will be in a lump sum or scheduled payments over time. It's also important to agree on a due date for repayment and whether there will be a penalty if payment isn't made on time.

Once you've agreed on the basic terms, don't stop talking. Set expectations for who's going to keep the conversation going, especially if there's a problem. Will it be up to you to chase down the borrower if a payment is missed? Do you expect the borrower to contact you if they can't make payment? Are you willing to renegotiate the terms if the borrower can't honor the original agreement?

When I lend money to a family member, I'm usually flexible if things get tough. I don't want to lose a cousin over a couple hundred dollars. But if the same people are constantly in need of a loan, I've learned how to say no without destroying the relationship.

Whether or not you make a loan, you can help a family member become more self-sufficient by sharing ideas on budgeting, saving, and the importance of having an emergency fund. Point them to money management articles—SchwabMoneywise.com is a great resource. Talk to them about some of the basic ways you manage money to stay on top of bills and out of debt. Maybe suggest a financial counselor. Some people won't be receptive to your ideas, but I think it's always worth a try.

There may be specific requests that offer you the opportunity to pay it forward, as I feel like I'm doing now. When I was just starting my career and needed money for my professional licenses, a cousin gave me $500 to cover the cost. My parents and my grandmother also invested in me. Now I'm paying it forward when I can.

So, while there are pitfalls to helping a family member financially, when you can be part of investing in someone's future growth and independence, the rewards can be wonderful.