Is a family loan a personal loan?
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UPDATED: Oct 5, 2012
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A family loan is indeed a personal loan, but simply one that is lent to a family member. Although family members very commonly lend money to each other, there are a number of tax implications involved in lending money. Further research and reading of personal loans questions and answers can help borrowers decide if a family loan is something they want to pursue.
The difference between a family loan, per se, and a traditional personal loan lent from an established lender is the involvement of a financial institution. Family loans are simply made between two relatives or friends: a lender and a borrower. Personal loans on the other hand, are often offered by banks and credit unions—not exactly flesh and blood family members.
When lending to or borrowing from a loved one, both family members must agree on the terms of their personal loan. They can protect themselves by creating a promissory note which details the contract of the lending agreement.
Promissory notes are similar to contracts in that they detail the lending arrangement and loan information. Contracts allow room for legal recourse—God forbid—by providing a record of the agreed-upon financing details.
What Should a Promissory Note Include?
The borrower and lender should include in their promissory note an explanation of how and when the loan will be repaid. By failing to discuss and document these two important lending factors, the loan is little more than a spoken agreement that would be difficult to enforce in court or in the case of an audit by the IRS.
A promissory note should also include details regarding the interest charged. Simply giving a family member an interest-free personal loan can cause legal and tax problems. Oftentimes, the IRS will consider such a transaction as a taxable gift. Therefore, it is important that both the lender and borrower ensure personal loans have interest rates attached.
The two family members can also decide whether or not to secure the loan with collateral. Examples of collateral would be items of value such as jewelry or a car. Offering a lender collateral can help sway a hesitant lender into giving money to a borrower. In the event that the borrower cannot repay the loan, then the lender will have legal grounds to seize the collateral as compensation.
Unfortunately, some family members do not believe promissory notes are necessary in order to borrow a personal loan. While family bonds may be strong, the need for legal documentation far outweighs any uncomfortable feelings that family may have about the lending process.