Family Loans and Cosigning a Loan
By Steve Gillman
There are some who will tell you that family loans are just
a bad idea all around. However, it is really a matter of the
particular family and what is expected. For example, in my own
family, loans are expected to be repaid - period. Because of
this it is not a big deal to bring up a late payment or other
issues. Interest is charged and usually at a rate which at least
replaces the income that would have been made if the money stayed
in the bank.
On the other hand, there are families that consider it rude
to expect or talk about repayment of a loan, or to charge interest.
In these cases, why call it a loan if it is clearly a gift? In
fact, even if it is repaid, but without interest, it is a gift
of the interest lost (or what the borrower would have normally
paid a bank). This kind of dishonesty generates bad feelings.
If a gift is asked for, call it that.
Apart from the nasty relationship problems that can arise
from family loans, there are the tax issues to consider. If you
loan larger amounts, like the money for a down payment or to
buy a car, the Internal revenue Service will likely assume an
"imputed interest" rate, even if the loan is interest
free. .In other words, you may get the money back, but in the
meantime pay taxes on the assumed interest collected.
Cosigning a Loan
Some parents or brothers or sisters help their children or
siblings by way of "loaning" their good credit in the
form of cosigning on a loan. Is that a good idea? Almost never.
A son or sister or daughter or brother only needs you to cosign
because a bank has determined he or she is too risky to loan
money to. Lenders are better than you at determining these things
than you - really.
In addition to the credit risk of cosigning, which I'll get
into in more detail in a moment, there is the real risk that
you won't actually help your loved one. For example, more often
than not, when parents help a child by cosigning on a car loan
they just help him or her into a debt that may last beyond the
life of the automobile. Debt for consumer items is a bad habit
that we shouldn't help others develop. "Helping" friends
and family into more stress and trouble is all too common.
What about your credit rating risk? When you cosign a loan
you are legally obligated to to pay if the borrower defaults.
That much you probably understand, but you may not know that
in many states the law doesn't require creditors to notify a
cosigner if the borrower is late on payments. In that case you
not only become liable for the debt, but you also get a black
mark on your credit report before you even know there is a default
or late payment.
Assuming there is a good reason to help a family member, here
are three safer ways to use instead of cosigning a loan:
1. Put up collateral for a loan.
Deposit the amount of the loan in an interest-bearing account
and let the borrower use it as collateral for a loan if your
bank or theirs permits this. Of course you'll lose the money
if your family member doesn't make the payments - you're on the
hook for the whole amount if you cosign anyhow. But this way
your credit rating won't be affected, since your name won't be
on the loan.
2. Lend the money yourself.
Assuming you can afford to lose the money (and if you can't,
why would you ever consider cosigning a loan?) just lend the
money yourself. But charge a reasonable interest rate to make
up what you lose taking the money out of the bank.
3. Help them establish credit.
To help a son, daughter or other family member establish credit,
put them on your credit card, or on a loan that is in your name.
They get to build a credit history, but the monthly statements
will come directly to you. That way if they are making the payments
you'll know if there is a problem.
With the right money beliefs and relationships family loans
can be a great idea. They can help a person start a business,
or pay for education or get proper medical care. Just keep it
honest and sensible - and protect yourself.