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Thinking About Borrowing from Family or
Friends? Do It The Right Way
Whether it's for a business, a home or a new car, there's
something very attractive about the idea of asking friends or
family for a loan. Nobody's worried about a credit check or the
other lengthy documentation and you can still hang out with your
lenders at the holidays.
In 2005, the National Association of Realtors reported that
about 9 percent of first-time homebuyers made their purchase
with help from a friend or relative, up from 5 percent in 1999.
About 25 percent of new homebuyers get money from a relative or
friend, a portion that's remained fairly constant over the past
decade.
Yet there are good and bad aspects to private loans. The good
news first:
- Terms can be
significantly friendlier than a borrower would qualify for
in the open market. For example, the rate charged on the
loan can be higher than the lender would receive in a
deposit account but lower than the borrower would pay a
commercial lender.
- They can require little
or no collateral.
- It's a way to keep
money in the family.
- It's a way for a
borrower to be able to buy a home, a car or other critical
assets even if they have a poor credit rating.
- There's no loss of tax
benefits to the borrower or lender if an agreement in the
case of a mortgage loan is structured and reported properly.
Then the bad news:
- Unclear agreements can
lead to missed payments or default.
- If the borrower dies
suddenly, the lender's investment may be lost if the
agreement isn't structured correctly. A properly executed
promissory note is still an obligation of the estate, and
may continue to be paid to an heir or other person or entity
based on the terms as agreed.
- Jealous relatives could
say they weren't treated fairly.
- Disagreements between
borrower and lender could kill an important relationship.
The best arrangements are formal — written in proper legal
language, notarized and recorded in the county where the
property resides. A financial adviser can talk to both parties
about what such loans — particularly real estate loans — can
mean for their respective finances. It also makes sense for both
parties to visit their respective tax professionals to make sure
they know the correct ways to document the loan transaction over
time for tax purposes.
A detailed document — prepared with the help of an attorney —
can also lay out specific scenarios if either the borrower or
the lender has to break or alter their agreement. Such trained
experts can talk you through the benefits and pitfalls of a
private loan arrangement as it affects your particular situation
(either as lender or borrower) and specific laws and
requirements in your state you have to follow if both borrower
and lender are going to derive tax advantages from the
agreement.
Generally, any private loan transaction should include a
promissory note that establishes how the debt will be repaid.
That's true for business loans or loans for most types of
property. In the case of a business loan, it makes sense for the
potential borrower to get specific advice on how lenders in
their business will be treated not only in terms of repayment,
but default.
In the case of a loan made for real estate, a mortgage or
"deed of trust" statement (depending on the state you
live in) or an agreement specific to the type of loan that binds
the property as collateral for the promissory note will be
necessary. It basically says that if you don't fulfill all the
terms in the agreement the lender has the right to foreclose or
repossess the property.
Even if a friend or relative makes an offer of help, it's
proper for the borrower to take the initiative to structure the
arrangement in a way that's responsible and beneficial to both.
If a relative is drawing income from the loan, special
provisions should be made for prepayment and other
contingencies.
The most important thing to remember and plan for? When two
people who are close to each other enter into such an
arrangement, the most valuable thing really isn't the money.
It's the relationship.
October 2007 — This column is produced by the Financial
Planning Association, the membership organization for the
financial planning community, and is provided by Don McCarty of
Financial Decision Partners, a local member of the FPA.
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