A new study confirms a fact most financial advisors are already acutely aware of: Intra-family lending can cause problems.
They also know well that clients will rely on them to prevent those problems before they spiral out of control.
Research firm FinanceBuzz released a study this week showing 46 percent of respondents have either borrowed or lent a significant amount of money ($250 or more) to family members. Only 56 percent of lenders were fully paid back, according to the report. However, lenders kept realistic expectations with 31 percent never expecting to get their money back.
More than a quarter of lenders (26 percent) had to set up a formal payment plan to get their money back, while 25 percent reported that lending money led to awkward family interactions and hurt feelings, the study said.
Nearly 1 in 4 lenders (24 percent) say that giving money to a family member had a negative impact on their relationship with the borrower, according to the report. Only 15 percent of people who loaned money to family members said it was a good idea.
So if there is nowhere else for a family member to turn when it comes to obtaining a loan, and knowing there is a significant chance the transaction could end badly, what’s the best way to do it?
It all starts with communication, according to Matt Liebman, CEO of Amplius Wealth Advisors
“Both parties should be transparent about the purpose of the loan and the timing and plan for paying the loan back. Regular check-ins help as well so that all parties are apprised of any developments that could impact the payoff,” Liebman said.
Liebman added that structure is of critical importance when it comes to intra-family loans. At a minimum, the loan should be documented and the terms and interest discussed with the family’s wealth and tax advisors to maintain compliance with IRS regulations regarding loans.
“One popular solution we have used is having the would-be lender put up securities as collateral and having a bank make the loan collateralized by those securities. While adding a third-party institution can add complexity to the loan, the arm’s length setup can have both quantitative and qualitative benefits for the family,” Liebman said.
"Plan for the worst, hope for the best" when it comes to intra-family lending, advised John Mosher, partner and vice president at Unique Wealth.
Mosher points out that typically lending is done between parents and their children. As a result, Mosher tells clients to use this as a learning experience for parents to see if their children will be faithful to pay them back under the terms of the loan.
“If they’re faithful now, they’ll typically be wise with a potential inheritance down the road,” Mosher said.
Mosher said most loans are usually interest-only with balloon payments at specified time intervals. Like Liebman, however, he believes it typically isn’t the structure of the loan that is as important as utilizing a third-party intermediary to be responsible for collecting payments thereby adding an additional level of accountability to the borrower.
Honesty remains the best policy, and especially if your relative foresees a problem with repayment by the date you’ve agreed to, said Barbara A. Pietrangelo, financial planner at Prudential Advisors.
“They should feel comfortable sharing that with you so you can work on an adjusted plan,” Pietrangelo said. “Avoidance only adds to a difficult situation and can often cause division within a family. It’s important to be prepared for the possibility that the loan may not be repaid, so don’t overextend yourself and try not to let that impact family relationships.”
She also reminds those lending the money to be empathetic and maintain open, positive communication throughout the process.
“You always want to set the relative up for success so hopefully they will not need to ask for a loan in the future,” Pietrangelo said.
Moving on, David Brown, investment advisor and founder of Magellan Wealth Advisors, part of Prospera Financial Services, first asks clients why the family member can’t get a loan from a lender. If it’s a good reason, such as the interest rate is too high, and the individual is responsible about paying their bills, then he recommends drawing up a contract and loaning the money.
If the family member's credit is poor, or this person has a history of being financially irresponsible, however, then he advises that they refuse the loan.
“Clients also need to consider the potential returns they will lose if they sell investments to make the loan,” Brown added.
Despite the horror stories, family lending need not always be viewed in a negative light.
Kate Atwood, founder and managing partner of Founders Grove Wealth Partners, refers to the concept of a "family bank" as a powerful tool for achieving financial goals. In her experience, family members who can provide financial assistance to other family members often find great satisfaction in supporting them when they need it most. Meanwhile, those who receive assistance benefit from preferred financing they might not otherwise qualify for or that would not be offered by a traditional bank, such as lower interest rates and flexible terms.
“Once the agreement is in force and funds have been distributed, it is important to make it easy for each party to make and receive payments. Electronic payment methods such as bill pay, Venmo, or Zelle are incredibly beneficial. Each party can track payments and deposits at their convenience, helping to maintain smooth family relationships, especially when money is involved,” Atwood said.
“Intra-family loans can be beneficial in financial, tax, and estate planning considerations. If you lend funds to a family member and decide not to charge interest, it is important to understand the annual gifting exemption rules.”
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