Marshall Gile was studying investment options for his retirement funds when he had a change of heart. He concluded that helping his daughter and son-in-law with a mortgage might offer the best return, emotionally if not financially.
When the couple moved from Chicago to Denver, Gile financed their mortgage through Circle Lending, an online company that formalizes and automates loans between friends and family.
“He came to us and said he was willing to do it if we wanted to. It was a legitimate mortgage where we could take the interest deduction,” said Gile’s son-in- law, Joseph Morris.
Every month, Circle Lending pulls money out of the Morrises’ account and deposits it into Gile’s.
Although each side can set whatever interest rate they want, federal tax laws require a minimum. Any interest below that minimum is considered a gift and taxable to the borrower.
Although Gile could have asked for a market interest rate, about 6 percent at the time, he went with the minimum, allowing Joe and his daughter, Caitlin, to buy a home both bigger and closer to his.
That was one benefit. Another is that the loan has solidified the relationship with his son-in-law, Gile said.
“It is a vote of confidence that we are willing to participate in a financial deal this way,” Gile said.
The “informal” loan market between family and friends is hard to measure, but estimates place it at about $89 billion, said Asheesh Advani, president and founder of Circle Lending. When loans are made with just a handshake and a promise, the default rate is unusually high – about 14 percent, he said.
One of the mistakes people make when loaning money to friends or family is creating an IOU with one big lump-sum payment.
“That lump sum is very hard for people to afford,” Advani said. “One of our original insights was to create repayment plans that work. We create a monthly payment plan.”
Another mistake is not having a backup plan should the borrower fail to make payments.
A poorly structured loan can not only cause financial hardships for the lender but bankrupt a relationship as well, cautions the National Endowment for Financial Education in Denver.
Circle Lending plays the intermediary should a loan go into default. Backup plans can include allowing a certain number of payments to be skipped until a borrower gets stable again.
Advani said the default rate on Circle Lending mortgages is about 1 percent, not much different from the national average. So far, Circle Lending has not had to pursue any foreclosures.
In fact, more people are turning to family members for more flexible loan terms as a way to avoid losing their homes, he said.
“When someone asks you for money, the person expects to be paid back. People value their relationships a lot,” he said.
As for Gile and Morris, having Circle Lending as a middleman means they never have to discuss the loan. And they prefer it that way.
Staff writer Aldo Svaldi can be reached at 303-954-1410 or asvaldi@denverpost.com.
What you need to know before loaning money to a family member
Looking to family members for a home loan may seem easy, but such loans are more complex than they may appear. Here’s how to navigate one without causing a family feud, according to the Colorado-based National Endowment for Financial Education:
- Be realistic about repayment. Many family loans are never repaid, which often leads to feelings of bitterness and betrayal. Another option is to make the money an outright gift.
- Ask yourself if you can afford the loan. If you can’t, don’t jeopardize your retirement or a child’s education fund by making a risky loan.
- Talk about the emotional consequences of a loan. When money enters into family relationships, the dynamics change, especially when the borrower is more vulnerable and dependent than the lender. As the lender, ask yourself if you think the loan will give you the right to influence the borrower’s personal decisions. Thinking so can create stress and family conflict.
- Understand the tax implications. The rules governing the taxation of a family loan are complex enough to cause many people to think twice about making one. For example, interest earned on a family loan is considered taxable income and must be reported on your income tax return.
- Make the loan an “arm’s length transaction.” In other words, handle the loan to your relative as you would one with a stranger. State in writing the amount of the loan, the interest rate and the repayment schedule. That way, if your relative is unable to repay the loan in full, you will have proof that a loan occurred, and you may be able to deduct the loss from your taxes.
- If you think you could be approached by family members for loans in the future, you might want to have a loan policy. This policy would detail the types of loans you consider making, the interest rates you plan to charge, the down payment you require and any other essential criteria. This policy can help formalize and impersonalize the transaction.
