Giving credit to the family Lending money to a relative can be risky business

October 06, 1993|By Kim C. Flodin | Kim C. Flodin,Contributing Writer

In today's economy, it's tempting to turn to a relative to help make a down payment on a home or pay out a semester of college tuition.

Borrowing from family members is generally easier (you don't need collateral to qualify) and cheaper (interest, if charged, is usually lower) than getting a bank loan.

But as many discover too late, lending money to family members is not always smooth sailing.

"There's a naivete that because this is family, it'll all work out," says Jim Gottfurcht, a Los Angeles-based psychologist who specializes in money issues.

But if things go awry over family loans, more than investments are vulnerable. Family ties are also at risk.

If you're contemplating borrowing from or lending to a relative, you can avoid the major pitfalls by considering these issues:

* No matter how good intentions are, some loans should never be made or sought.

Mr. Gottfurcht suggests that borrowers ask for a loan only if they have a realistic plan for repayment. And be prepared to be turned down -- your relative has a right to refuse.

Lenders should give only money they can afford to lose.

* While some lenders presume a right to have a say in the lives they partially finance, it's healthier to avoid doing so.

When Cathy, a teacher's aide in Patchogue, N.Y., borrowed money from her parents to buy a new sofa, she found this out the hard way.

"I really wanted to look at sofas done up in completely different materials. But my dad was getting impatient and so all I had to go by were these silly little fabric swatches.

"Then my mom lectured me on how blue limits your choices and earthy colors are more versatile.

"With the two of them in agreement and footing the bill, I felt pressured to make a decision and caved in."

Instead of the cool, blue sofa Cathy had imagined, she now stares daily at a floral print in rust tones.

"Unless it's an emergency, I'm never turning to my parents again," Cathy says.

* Explore emotional expectations and discuss them openly. "Flushing out what bothers you in the beginning goes a long way toward avoiding hurt feelings later," Mr. Gottfurcht says.

One issue might be deciding whether to publicize the loan among other relatives.

Some people are proud of their ability to help family members and don't see the need to keep it under wraps. Others would disagree, believing finances are a personal matter. Whatever your opinion, make sure both parties concur.

Be businesslike

Jeffrey Levine, a certified financial planner (CFP) and tax attorney in Albany, N.Y., recommends that both parties discuss the fiscal terms of the loan and then put the agreement in writing.

Ask yourself these questions:

* Is it a loan or a gift? "Ambiguity causes complications when, for instance, someone who thought she was getting a cash gift has to pay back the money," Mr. Levine says.

If, as a lender, you don't want or need to be paid back, clearly state that the money is a gift. If, as a borrower, you're getting mixed signals,ask the question directly.

Before accepting a family loan to help purchase a home, make nTC sure your monthly debt will not disqualify you for a mortgage.

The Mortgage Banker's Association of America says lenders generally check whether a prospective home buyer's future housing expenses (including mortgage payments, insurance and taxes) will not exceed 25 percent to 28 percent of his or her gross monthly income. For Federal Housing Administration (FHA) loans, that figure is 29 percent.

Additionally, any loan payments or other expenses that extend more than 10 months into the future should not exceed 33 percent to 36 percent of the home buyer's gross monthly income. (FHA-insured lenders allow 41 percent.)

If a relative decides to give you money toward your down payment, your bank will want a statement, signed by you and your benefactor, stating that the money is a gift and is not to be repaid.

But don't expect to saunter into a bank with your whole down payment from relatives.

According to the National Association of Realtors (NAR), most lenders want at least 5 percent (for FHA-backed loans, 3 percent for the first $25,000, 5 percent thereafter) of the total purchase price to come directly from the borrower -- regardless of whether the rest is given or lent to the borrower.

"You won't get away with letting Mom and Dad deposit a couple of thousand in your account a few months ahead of time," says Mary Fruscello, the vice president for NAR's real estate finance division. Banks ask for lots of backup records.

"Your best bet is to be honest about family loans and gifts and have the proper documentation ready."

* Who is getting the loan? If you lend money to your married brother, stipulate whether his wife is a co-borrower and, therefore, bears part of the responsibility for payment in the event of death or divorce.

* Will interest be charged? Many family loans are interest-free. But Terry J. Siman, a Philadelphia-area CFP and attorney, suggests interest be charged for loans of more than $10,000.

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