By Beau Ruff
Times can get financially rough. People go through difficult periods in life and might be strapped for cash and need an additional sources of money. Perhaps the cash is needed to buy a new house or to pay for a small business or an attorney’s retainer for a divorce or to tackle the mounds of consumer debt incurred during the holidays … or any other number of reasons.
One simple and convenient source of money is family and friends. You just need a little and can pay it back quickly, so it makes sense, right?
Family and friend, beware: these loans are fraught with peril. Here are some rules to help guide you to avoid the worst of the perils.
Rule No. 1. Don’t lend money to family and friends. That’s it. But, if you must lend, keep reading the rules below.
Rule No. 2. Get it in writing. The promise to pay you back should be outlined in writing. This is important for two reasons. First, it allows the transaction to be more easily enforceable. Second, and maybe more importantly, it makes sure that both parties understand all the terms of the transaction. The document should fully describe the transaction and contain, at a minimum, the following: (1) the amount of money to be loaned; (2) the date of the loan; (3) the rate of interest; (4) the repayment schedule; (5) whether prepayments are authorized (they usually are in this type of transaction); and (6) what happens when a payment is missed (usually that equals default with some specified default remedies).
The writing is usually accomplished through a Promissory Note, which is a promise from one person to pay another person recognized in the law as being similar to a check.
Rule No. 3. Charge interest. At least, consider charging interest. If you provide money to a family member or friend and you do not charge interest, you could be making a potentially taxable gift. On a monthly basis, the Internal Revenue Service publishes in a Revenue Ruling the least amount of interest that is necessary to avoid gifting implications. The interest rate is called the Applicable Federal Rate and is based on the term of the loan. You can find the rate online.
Rule No. 4. Consider collateral. The greater the amount of the loan, the greater amount of security you will need. Security is the collateral for the transaction that ultimately you may be able to seize. Let’s say you are going to loan money to help with a down payment on a house. This can be a considerable sum of money. The lender would be wise to consider the collateral (perhaps the house that is being bought) and take a security interest in the house through a mortgage or a lien. Without the security interest in the collateral, the lender is a general creditor and stands in line to receive payment after the secured creditors (those who have a mortgage in the house). The better position to be in as a lender is to be a secured creditor by placing a lien or mortgage on property. This moves you up the line to collect your money if some tragedy should befall that friend and repayment is unlikely. A lender can take a security interest (like a mortgage) in assets that are not the subject of the loan as well. For example, if you lend $20,000 for a wedding, you can still potentially take a mortgage in the couple’s house.
Rule No. 5. Hire an attorney. An attorney can ensure that all the rules are followed and help make sure you are in the best position to protect your assets.
Rule No. 6. Never lend more money than you are willing to lose. Despite all of the above rules designed to protect the lender, losses can and will happen. And, the reality is that the lawsuit to collect the sums owed can be long, costly and extremely emotionally taxing. And such a lawsuit is likely to cause grave harm to the relationship that existed prior to the loan. For these reasons, a person lending to family or friend should be willing to walk away from the deal without collecting a dime, even if all the other aforementioned rules (excepting Rule No. 1) are followed and the lender has a promissory note secured by a house with a market-rate interest rate and all of it orchestrated by a top-notch attorney.
Rule No. 7. Don’t lend money to family and friends.
About Beau Ruff:
Attorney Beau Ruff works for Cornerstone Wealth Strategies, a full-service independent investment management and financial planning firm in Kennewick, where he focuses on assisting clients with comprehensive planning.