What Is a Family Loan?

How family loans work

Family loans are issued without credit checks, can have lower than market rates and payment schedules can be more flexible if necessary. On the other hand, traditional personal loans require credit checks, market interest rates and strict payment schedules.

Family loans have relatively low interest rates and flexible terms.

These arrangements can benefit both parties. The lender can earn interest on their funds, and the borrower can receive a flexible, low-cost loan. If you loan or borrow more than $10,000, interest must be charged.

What are family loans used for?

Family loans can be issued for any purpose, but they are commonly used to:

• Make a large purchase
• Down payment on a house
• Consolidate debt
• Start a business
• Pay for school

Pros and cons of family loans

Family loans are a cheap and convenient way to borrow money, but they come with a few drawbacks. They can be easy to qualify for, but family loans don't help the borrower build credit.

The biggest pitfall is that the loan could potentially cause turmoil between family members, especially if there are issues with payment. There may also be tax implications for the lender.

Creating a family loan agreement

The point of a formal loan agreement is to “ensure that the estate is able to collect the loan payments if the person to whom the money is owed (the lender, often an elderly parent) dies,” Evan H Farr, principal attorney at Farr Law Firm in Fairfax, Virginia, explained. “Without a written loan agreement or promissory note, the personal representative of the estate would not be able to collect the outstanding amount of the loan.”

In other words, a family loan agreement can go a long way toward maintaining a positive relationship with your loved one. It's important to clearly state the terms of the loan to avoid any miscommunication later.

Loan agreements also prove that the money is a loan, not a gift. This will impact the lender's tax return and gift-giving limits, but it will also help if either party passes away.

Pro tip

You may want to consider legal advice, according to attorney Evan Farr. "Legal advice is essential, especially if the loan is being made by or in relation to an elderly parent, as Medicaid rules must be complied with, and those are extremely complex,” he said.

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Key components of a loan agreement

Family loan agreements should include the following:

• Parties involved
• Amount of the loan
• Duration of the loan
• Interest rate
• Payment amount
• Due date
• Collateral 
• Late payment provisions
• Default terms

What could go wrong?

When loaning or borrowing money, it's easy to assume that everything will go smoothly. But be sure to include what happens when a payment is late. Decide when the payment is considered late, and whether a fee will be charged.

Also, if the loan defaults, decide what will happen and when. If there is collateral securing the loan, how will the lender take possession of the asset, and what will happen if the item doesn't sell for the full amount owed on the loan?

Tax implications of family loans

There are no tax implications on loans to immediate family members as long as the loan amount is under $10,000. The IRS does get involved for loans over $10,000. This means that the lender may need to charge interest on loans over $10,000.

Alternatively, the IRS can consider it a gift, rather than a loan. If it is a gift, then it goes toward the lender's annual gift-giving limits, which are $19,000 in 2025. If the lender exceeds the gift limit, they will need to file a gift tax form.

The interest rate for a family loan is between 4% and 5%.

The interest charged on the loan must be the lower of either the Acceptable Federal Rates (AFR) or the borrower's net investment income for the year. If the borrower's investment income is less than $1,000, interest doesn't need to be charged.

If the lender doesn't charge the required interest, the difference between the AFR and the actual interest is considered a gift to the borrower. This means it will count against the lender's gift-giving limits. Any interest that is charged will have to be claimed as interest on the lender's tax returns.

If the loan defaults and is forgiven, it becomes a gift and will count against the lender's gift limits. The borrower does not have to claim the forgiven loan as income in the same way they would if it were a traditional loan.

Alternatives to family loans

Lending money to family can create issues that go beyond money. Mixing money with family can change the dynamic, and as much as you want to help out your loved one (or be helped out), it may not be worth the risk. Here are some options for both lenders and borrowers if a family loan isn't the right choice.

Alternatives to lending money to a family member

• Gift: If you want to help out a family member and don't want the stress of having to be repaid, you may want to consider the money a gift. This allows you to do a nice thing without the risk of the borrower not paying you back and creating resentment.
• Co-sign: Co-signing for a loved one can be a compromise if you want to help them but aren't ready to lend them money. If you have good credit and a low debt-to-income ratio, you may be able to help them get their own loan by being a co-signer. It's important to understand that when you co-sign, you are legally responsible for paying the loan if the borrower defaults.

Alternatives to borrowing money from a family member

• Personal loan: If you can qualify, a personal loan may be your best option. You can use the funds for a variety of purposes, and you'll make regular payments to repay the loan.
• Home equity loan: If you have home equity, you may want to consider a home equity loan or line of credit. Since the loan is secured by your home, interest rates are typically lower; however, you may lose your home if you default on the loan.
• Credit card: If you only need a few hundred or a few thousand dollars, consider a credit card. Some cards are easy to qualify for, and you don't have to worry about losing any collateral if you default. The downside is that interest rates and fees can be high.