When four of Roger Jusseaume's nieces and nephews bought new homes last year, they didn't go through a bank or other institution for financing. Instead, Jusseaume, an Arizona entrepreneur, was more than happy to lend them the money. While few relatives can afford to be that generous--after all, there aren't many people who have the means to provide $500,000 worth of mortgages--loans between family members are common. Financial planners and family counselors often caution against the practice, but the Federal Reserve estimates that 2.1 million U.S. households owe money to individuals, including friends and family members. These loans may seem appealing, since they cut out the application process and give fast access to cash, but they come with plenty of risks for both the lender and the borrower. Credit counselors say many personal loans between family members go unrepaid, which can lead to anger and unraveling of close ties. And even when loans are repaid, they can create an unsettling change in the balance of power between relatives. That may be less of a problem between parents and children, but it can devastate sibling relationships.
"The person who borrowed becomes more vulnerable and feels less than the person they have borrowed the money from," says Kathleen Gurney, founder and CEO of Financial Psychology Corp., a consulting company based in Sarasota, Fla. "It's not a level playing field anymore." Resentment and guilt can build up, threatening even the deepest of bonds.
Toni Goldfarb, a writer in Old Tappan, N.J., says a five-figure loan she made to a close family member upset their relationship, even though they had a signed agreement and he was paying interest on the sum. The problem was both the repayment schedule--she says her relative paid her quarterly in "dribs and drabs"--and the fact that he lived a more affluent lifestyle than she and her husband did. It took more than five years for Goldfarb to be fully repaid. "He didn't think this was a big deal because he thought it was a fair exchange," says Goldfarb. "He was paying me a fair interest rate. He sees it as a success story, whereas I still have negative feelings about the whole thing." Nonetheless, she says, she would lend her family member money again without hesitation.
Emotional issues aren't the only reason to think twice about family loans. There can be financial consequences too. Borrowers--especially those with limited credit histories--miss out on the chance to build their credit rating when they borrow money privately. This can be a hindrance for them later in life when they apply for a car or home loan.
Lenders, of course, lose access to, and often interest on, their money. But there can be other costs as well. For example, unless lenders charge interest on their loans at the prevailing market rate, they may be liable for the difference if they're audited, says Brent Neiser, director of collaborative programs at the National Endowment for Financial Education. And if they fail to charge any interest at all and don't set repayment terms, the loan can be considered a gift that is subject to IRS gift-tax rules. Depending on the sum, the tax can run as high as 50%.