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Do You Know how to protect yourself when making a loan to a family member?
Formalizing a loan between family and friends may seem cold and ungenerous, but there are financial and emotional benefits to doing so. Being able to spell out those reasons may even ease tensions and give you a framework for discussing the deal. So before you make any commitments, remember these five points.
SIZE UP THE LOAN – To do this, size up the loan as if you were a bank. Carefully assess the borrower’s finances, why they are asking you for money and how they intend to repay you. You also need to evaluate what you would be doing with this money and would you be able to lose this money if they didn’t repay it.
EVALUATE THE EMOTIONAL FACTORS – Since it is a family member, you need to consider whether the relationship could survive if the loan was not repaid
Also, look at the personality of the potential borrower. If they have a bad temper or have trouble communicating, you may want to think twice about getting involved.
SET THE TERMS- Spell out the terms of the loan upfront. If you’re not comfortable asking these questions, say you need to know when and how often the payments are going to be made and at what interest rate for tax purposes. This will make your borrower think about their ability to repay the loan.
DOCUMENT THE DEAL- Formalizing the loan gives you some protection and lets the borrower know you view it as a serious business. Having your borrower sign a contract you obtained from an office supply store or even a memorandum of understanding of repayment should be sufficient to protect you.
CONSIDER TAX IMPLICATIONS- If you’re earning interest off this loan, you will need to declare it on your tax forms. If your borrower defaults on the loan, you can write it off as a bad debt however you will need to document your attempts to collect this money either by a certified mail receipt asking for the money or a letter from your borrower saying they cannot repay the loan.
Doing these five things may feel awkward, but it is a small price to pay to safeguard your relationship and your money.
Kathi L. Schear
Adapted from an article on personal finance by Candice Choi, AP writer..