Interest rates have risen at a record pace in 2022, with many experts anticipating further rate hikes occurring into the new year. With rising interest rates, borrowers face higher interest costs on their debt and other financial obligations.
You may be sitting on a sizable level of cash reserves, and a family member or close friend may need access to liquidity. It is possible that making a personal loan may result in a higher yield than you are earning on the cash in your savings account, and the borrower may find that the interest rate they pay may be more favorable than what they can obtain with a more traditional lender (i.e., bank, credit union, etc.). In many instances, this could be a win-win scenario. If not done correctly, however, it could lead to significant problems.
Personal Loan Considerations
If you are considering making a personal loan, there are several factors you need to be aware of to comply with current IRS rules and regulations. First, be sure you and the borrower are aware of the pros and cons before making any final decisions.
- Be clear about whether this is a loan or a gift and document everything accordingly. As a safety measure, if ever in doubt:, document, document, document! When money exchanges hands between family members, the IRS views this as a gift unless there’s evidence that the lender expects it to be repaid. While a loan to a family member can be a great thing for both parties, money creates many different emotions, leading to difficult conversations and the possibility that relationships may be impacted.
- Ensure you charge an appropriate interest rate, which the Internal Revenue Service requires. The IRS publishes monthly rates known as the Applicable Federal Rate (AFR), which outlines the minimum interest rate a lender must charge a borrower for loans over $10,000. The AFR varies based on the length of the loan term.
- Create a formal loan agreement. Have an independent third-party sign and notarize the loan agreement after the lender and borrower have each signed it. Be sure each party receives a copy of the signed agreement.
- Prepare an amortization schedule. An amortization schedule is important, so the lender and borrower are both aware of the loan terms and how repayment will work. The amortization schedule should clearly outline how payments will be applied to both principal and interest. Be sure to consider the impact of early or additional payments towards the principal balance and how this may impact the loan payoff date.
- Have a plan in place if payments aren’t made. For example, are you prepared to seize or foreclose on the purchased item if the loan is to a family member or close friend? Be clear about what the ramifications are for late or non-payment.
Should this Loan Be a Gift?
If it’s clear this is too much trouble or if it has the potential to lead to a damaged relationship, consider making a gift instead. In 2022, the annual gift exclusion amount is $16,000 (scheduled to increase to $17,000 in 2023). This gift exclusion means individuals can give any other individual $16,000 without filing a Federal Gift Tax Return (known as IRS Form 709).
If you are married, you and your spouse can each make a gift of $16,000, known as a split gift. This doubles the amount a couple can give to any individual during a year.
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