How To Take Out a Loan From Your Parents
You need money and you’re hoping to get it from the two people you’ve always relied on most: Mom and Dad. They’ve always been there for you in the past, so you’re hoping they’ll agree to help you out this time.
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Whether you wouldn’t qualify for a traditional loan or are simply hoping to get the money you need without the help of the bank, your parents can be a great resource. Of course, you have to get them to agree to it first.
Make a Formal Request
Levon L. Galstyan, a certified public accountant at Oak View Law Group, based in Glendale, Calif., said it’s OK for an initial loan conversation to come up on the phone or at brunch with family, but a serious talk needs to take place in a more formal environment.
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“They should take place at a predetermined time, and in private, to help prevent any aggressive remarks or more severe concerns raised in a public environment,” he said.
Before approaching your parents about the loan, he said, you should have considered all alternatives, since they might want to know why you didn’t choose a more traditional option.
“Be prepared to discuss what you have done to make changes or how the loan is a step towards improving your financial health, if you have bad credit or little money,” he said.
He also recommended consulting with a lawyer and working to develop a formal arrangement. This includes offering up collateral to show you’re serious about repaying the loan.
How To Pay It Back
If your parents agree to the loan, Galstyan said, you’ll want to make sure to keep track of your payments.
“One technique to ensure payments are made on time is to set up periodic calendar reminders,” he said.
He also suggested setting up autopay.
“By doing this, you may finally pay off the debt and ensure that you never miss a payment,” he said. “Additionally, since the payments would be smooth and automated, you won’t ever argue about the loan or talk about it.”
He also said it can be a good idea to create a contingency plan for repayment.
“Your parents might not need to worry too much about the effects of your early death or incapacity,” he said, “if they have the adequate financial stability to withstand delinquency or default.”
However, if you want to give them extra security for repayment, he said, you can include certain conditions in your promissory note.
“For instance, while the loan is still open, you might designate your parents as the beneficiary of a life insurance policy or retirement plan,” he said. “If you are a family person, you might need to take more time to prepare for unforeseen events.”
Even when your parents are the lenders, Galstyan said, you still need to take several elements of the loan into consideration, including:
- Your repayment strategy — including whether you have enough money to repay the loan
- What you’ll do if you miss one or more payments
- Whether you plan to tell your parents why you need the loan
- Your parents’ right to offer suggestions on your spending habits, job path and time priorities — especially if you don’t repay the loan on time
- How your potential inability to repay the loan — e.g., in the event of an accident — could impact your parents’ finances
- If you’ll consent to having the payments reported to credit bureaus to establish credit.
Putting It in Writing
You might not think you need to get a loan from your parents in writing, but Galstyan recommended otherwise.
“Putting the terms in writing is preferable for everyone,” he said. “With your parents, this could come out as being unnecessarily formal, but it helps both your parents and you to understand what was agreed upon.”
As for what to include in the agreement, he said it should specify the parties involved, the size of the loan, duration and interest rate.
“Think about any late payment penalties and the best method of payment, such as an electronic bank transfer,” he said.
He said you might also want to include your parents’ options if you don’t keep up with payments, including collateral.
“Promissory notes using standard words, for instance, are available in internet resources and public libraries for people who feel comfortable drafting it themselves,” he said. “You and your parents must be able to execute contracts and comprehend the provisions of your loan arrangement in order to sign it.”
To make the contract more authentic, he recommended having it witnessed and notarized. Additionally, he said your parents might want to speak with a lawyer.
Of course, there are tax consequences to consider when taking out a loan from your parents.
“The family member who loaned the money might need to submit a gift tax return if the transaction was over $15,000 and interest-free,” Galstyan said. “If the loan has an interest, the lender must abide by IRS regulations on interest rates and may be required to disclose the amount as income.”
Specifically, this type of loan is referred to as an intrafamily loan, said Aviva Pinto, managing director at Wealthspire Advisors LLC, headquartered in New York City. She said these typically use the Applicable Federal Rate (AFR), the lowest interest rate that can be charged on a loan for it not to be considered a gift.
“The IRS has three rate tiers for the three different terms of loans,” she said. “A short-term loan, 0-3 years; a mid-term loan, 3-9 years; and a long-term loan, 9 years or more.”
Presently, she said the rates are less than 3%.
“If interest is not charged, the IRS will consider the loan a gift and it could have tax consequences,” she said. “Consult your parents’ tax accountant before taking out the loan.”
So there you have it: If done properly, taking out a loan from your parents can be a positive experience. Formalizing terms and working with the appropriate financial professionals is a great way to cover all the bases and make everyone feel protected.
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