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Should You Be a Borrower or Lender? The
Return of the Personal Loan
As lending requirements stay relatively tight for most
consumers, the chance of borrowing outside the banking system
from family or friends can be attractive. After all, it's rare
to see a parent or sibling demand a credit check or other
lengthy documentation.
On the other hand, it could be one of the most dangerous
financial transactions you ever make simply because money can
drive a wedge between relatives in even the closest of families.
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.
Now 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 advisor such as a CERTIFIED
FINANCIAL PLANNER™ professional can talk to both parties about
what such loans — particularly large loans for real estate or
tuition — 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 or
a certified public accountant 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.
You should be aware that the IRS governs these interest rates
and provides an annually updated table that you can get
at http://www.irs.gov/app/picklist/list/federalRates.html —
these rates are Applicable Federal Tax Rates (AFR). You can
also forgive a portion of the loan each year up the annual gift
exclusion which is $13,000 this year.
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. These agreements are particularly important for tax
purposes as well.
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.
February 2010 — 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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