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Often, the topic of Inter-Family Loans comes up in my discussions with clients. Many times a parent wishes to help out a child with the purchase of a home, or some other financial goal – but they don’t want to just hand over the money with no responsibility attached. Inter-family loans can be a good way to approach this topic – the child continues to have fiscal responsibility, and the parent is able to earn a bit on the loan, while still feeling as if they’re in a “helping” position with the child. Below are a few items to think about, along with the additional topic of co-signing loans with family members.
Should I lend money to a family member?
Lending money to a family member may seem like the right thing to do. After all, what could go wrong? Your son, sister, father, or cousin really needs your help, and there’s no question that he or she will pay you back.
Or is there? Lending money to anyone, even someone you trust, is risky. No matter how well-intentioned the borrower is, there’s always the chance that he or she won’t be able to pay you back, or will prioritize other debts above yours.
When deciding, consider these tips:
- Don’t lend money you can’t afford to lose. If you make the loan, will you still be able to meet your savings goals? If the loan isn’t paid back, will the financial effect be negligible or substantial?
- Avoid becoming an ATM. Relatives (especially your children) may ask you for a loan because it’s convenient, but they may be able to obtain the money easily elsewhere. Explore other options with them first.
- Think through the emotional consequences. Will you be able to forgive and forget if loan payments are sporadic or if the loan isn’t paid in full? How hurt will you be if your relative freely spends money (on a vacation, for example) before paying you back?
If you decide to go through with the loan, make sure expectations on both sides are clear. Discuss all terms and conditions and consider putting them in writing. You may even want to draft a formal loan agreement. At the very least, settle on the amount of each loan payment and the date by which the loan must be paid in full. Open-ended obligations inevitably lead to misunderstandings.
On the other hand, don’t feel guilty if you decide to turn down your family member’s loan request. It’s hard to say no, but it’s still easier than repairing a damaged relationship if things don’t work out.
Is it a good idea to cosign a loan?
At some point, you may be asked to cosign a loan for a friend or relative who is unable to qualify for one independently. While it’s noble to want to help someone you care about, think carefully about the consequences. Some people readily agree to cosign a loan because they believe it won’t affect their own finances, but unfortunately, that’s not the case.
When you cosign a loan, you’re guaranteeing the debt. The lender requests a cosigner because they want more than the primary borrower to be responsible for the payments – so a cosigner becomes responsible in the event the primary borrower doesn’t pay. Legally speaking, this means that you’re equally responsible for paying back the loan. If the primary borrower misses a payment, the lender can ask you to make the payment instead. If the borrower defaults on the loan, you may have to pay off the outstanding loan balance as well as cover late fees and collection costs, if any. In many states, creditors can even try to collect the debt from you before trying to collect from the borrower.
You should also keep in mind that when you cosign a loan, it becomes part of your credit history and may negatively affect your ability to get credit if the borrower makes late payments or defaults on the loan. And when you apply for credit, lenders will generally include the monthly payment for the cosigned loan when calculating your debt-to-income ratio, even though you’re not the primary borrower. This ratio is one of the most important factors lenders use when making credit decisions, so the outstanding loan debt could make it harder for you to obtain a mortgage, buy a car, or secure a line of credit.
Cosigning a loan is risky enough that the federal government requires creditors to issue a notice to all cosigners that explains their obligations. If, after careful consideration, you decide to cosign a loan, make sure you also get copies of the loan contract and the Truth-In-Lending Disclosure and thoroughly read them. Monitor the loan as closely as possible (you may want to ask the loan officer to contact you in writing if the borrower misses a payment), and occasionally review your credit report so that there are no unfortunate surprises down the road.