By CANDICE CHOI
AP Personal Finance Writer | Posted: Monday, November 24, 2008 12:00 am
NEW YORK - Digesting your turkey and sweet potatoes might be tougher this Thanksgiving, when that uncle you rarely hear from pulls you aside to ask for a loan.
So this holiday season, be prepared to protect your money (and the family peace).
Formalizing a loan between family and friends might seem cold and ungenerous, but there are financial and emotional benefits to doing so. Being able to spell out those reasons might even ease tensions and give you a framework for discussing the deal.
"When you're trying to collect on a debt, friends and family can quickly become estranged,'' said Ira Bryck, director of the University of Massachusetts Family Business Center.
So before you make any commitments around the dinner table, remember these five points.
1. Size up the loan
With certain loved ones, you might be comfortable making a loan with no strings attached. But if your ultimate goal is to recover your money, evaluate the request as if you were a bank.
This means carefully assessing the borrower's finances. Ask why your relative came to you and what other options were exhausted. Ask about her employment and how she'll earn the money to pay you back.
Because there's a chance you might never get your money back, only lend what you can afford to lose. Also consider the impact the loan will have on your lifestyle and long-term savings. Is this money you could sock away into a 401(k) or IRA account?
Any gains you'd sacrifice are heightened if the borrower is asking for an interest-free loan, which is really more of a gift.
"Look at it as if it were an 'arms-length' transaction. How would you do this loan if this person wasn't your friend?'' said Rob Setlzer, a certified public accountant based in Beverly Hills, Calif.
Otherwise, Seltzer said you're leaving yourself open to losing your money.
2. Evaluate emotions
There are always emotional risks when mixing family and money.
Consider whether the relationship could survive if the borrower doesn't hold up her end of the deal.
Personality is another factor. If the borrower has a bad temper or trouble communicating, you might want to think twice before getting involved. And don't forget the rifts a loan might cause with other loved ones.
You should also discuss who else in your family or social circle will be aware of the loan. You might feel certain family members have a right to know about it, while the borrower may ask that you not to mention it in front of their children or others.
"If it's a 'no', people should feel confident to say 'no,''' Bryck said.
3. Set the terms
To avoid conflict down the road, spell out the terms of the loan upfront.
Ask how payments will be made, over what time frame and with what interest. Forcing the borrower to think through such details might serve as a reality check - she might even realize she won't be able to pay back the money, after all.
If you're not comfortable requesting the information, say you need the specifics for tax reasons or to ensure you can meet other financial obligations.
If the loan is to start a business, discuss what rights (if any) you'll have as a stakeholder. This might include copies of quarterly balance sheets or a role on a board of advisers.
Be specific about how much oversight you'll be permitted. Otherwise, accusations about micromanagement may erupt later, Bryck said.
4. Document the deal
Formalizing the loan gives you some protection and lets the borrower know you view it as a serious business transaction.
"Going the extra step puts the person on notice,'' said Michael Eisenberg, president of Eisenberg Financial Advisers in Los Angeles.
For small loans up to a couple thousand dollars, a signed memorandum of understanding is usually enough to hold up in small claims court. Generic forms are available online or at office supply stores.
The catch is that collection might be difficult even if you win a small claims judgment, because there are few ways to enforce payment, said Bryck of the Family Business Center.
The cap for small claims court judgments varies from state to state, but generally is limited to no more than $10,000. Individuals represent themselves so there are no attorney's fees.
For larger sums, you might want to enlist a lawyer to draw up loan documents. This is a particularly good idea if there's collateral involved, such as rights to a car or home if the borrower defaults.
If the borrower wants the loan reported to a credit agency in order to build a credit history, consider using a service such as Virgin Money. The company, a unit of the Virgin Group, facilitates loans between family and friends either online, via phone or through a financial planner.
In addition to drawing up loans documents, Virgin can set up electronic money transfers or restructure loans if needed. Fees range depending on the service; the basic fee to set up a loan is $99.
5. Consider tax impact
If you're earning interest on a loan, it should be listed as income on tax forms. For borrowers, interest paid on loans is generally not tax deductible.
Defaulted loans can be written off as a bad debt - but you'll need to have the loan formalized so that you have the necessary paperwork to document your loss.
To support a tax writeoff, a letter from the borrower stating she can't pay you back might suffice, as might a copy of a bankruptcy filing by the borrower, Eisenberg said. If you can no longer get a hold of the borrower, mail her a certified letter. When the letter is returned, keep the receipt to show the IRS.
"This shows you made an effort to collect,'' Eisenberg said.
In the end documenting a loan may feel awkward, but the momentary discomfort is a small price for safeguarding your relationship and finances.
THINGS TO REMEMBER
The Associated Press
If you turn down a relative's request to borrow some cash, they may ask you to co-sign a loan instead. This may sound like a harmless alternative, but there are serious repercussions to consider.
Co-signing a loan isn't a mere character reference. If the borrower does not pay you are fully liable for the loan. This means you need to be in a position to make the loan payments if the borrower cannot.
You may also be liable for any late fees or collection costs.
So before co-signing a loan, remember these points from the Federal Trade Commission.
Risks to consider
• In many states, the lender can collect the debt from you as the co-signer without first trying to collect from the borrower if a payment is missed.
• Lenders can generally use the same collection methods against you as against the borrower, such as suing you or garnishing your wages.
• If the debt is ever in default, it may become part of your credit score.
• Even if you're not asked to repay the debt, your liability for the loan may prevent you from securing other loans or credit.
Protecting yourself
• Try negotiating the specific terms of your obligation. For instance, ask to limit your liability to the principal on the loan and exclude late charges, court costs or attorney fees. Ask the lender to include a statement in the contract similar to: "The co-signer will be responsible only for the principal balance on this loan at the time of default.''
• Ask the lender to agree in writing to notify you if the borrower misses a payment. This will give you time to deal with the problem immediately and potentially avoid any late fees.
• Ask the lender to calculate the amount of money you could potentially owe. The lender isn't required to do this, but may if asked.
• Get copies of all important papers such as the loan contract and any supporting documentation, and warranties if you're co-signing for a purchase. Since the lender is not required to give you these papers, you may have to get copies from the borrower.
• Check your state law for additional co-signer rights.
Source: The Federal Trade Commission