Loans of love: how to borrow from family and friends
Whether it's lending a tenner to a friend at the pub or helping a close relation with the deposit needed to buy their first home, loans between family members and friends are extremely common.
Unfortunately, so are disagreements about them.
Unpaid or disputed loans can negatively affect relationships and, sometimes, even sever ties forever.
Yet we keep making them. According to Scottish Widows' research, the number of these loans increased by 31% between 2007 and 2012.
A 2014 Payments Council study estimated that informal loans run into the billions; the results are shown in the pie chart below.
With rising living costs and the continued squeeze on wages, it looks like these trends are only set to increase.
But clearly not all loans between friends or family members end badly and, done the right way, an informal loan is a good deed: enabling a loved one to resolve a financial worry or fulfil a dream like a first home without the lender suffering financial loss.
So what is the right way? Here are three things we think any informal borrower or lender should consider.
1. Setting boundaries
Clear and open communication between lender and borrower will help ensure that the transaction doesn't go wrong at any point during the loan period.
Assumptions can be deadly: the lender might assume the money will be paid back quickly while the borrower thinks the money is, for all intents and purposes, a gift.
What to think about
Here are just a few things it's worth thinking and talking about before borrowing.
- Amount: how much to ask for - it can help to have a reason for a specific amount.
- Repayment: when and how are the important points here. If repayment depends on, say, taking a second job it might help to get that set up first.
- Consequences of default: similarly, although it's tough it's well worth considering the consequences of being unable to repay, both personal and financial, for both parties.
- Financial consequences: lenders could consider, for example, how losing the amount they lend will affect their ability to earn interest on savings or they still have enough in savings to be covered in an emergency like losing a job.
- Motivation: loans between family and friends often go bad because they are rooted in a dispute. Lenders that feel they've been pressured into giving money, for example, might feel later feel resentful that they've lost the amount.
Making the informal formal
If a personal loan is going to be treated as seriously as a bank loan, more than talk might be helpful.
A loan agreement will get the terms, time frame and interest of the loan down in writing.
If a repayment plan is specified, the document would also outline what happens if the borrower defaults on a payment.
Provisions could include a fixed penalty or an interest charge. Interest rates are often set so that the lender does not lose money over the period of the loan.
Agreements can also cover both parties in the event of all potential eventualities, however unlikely or disagreeable. For example, it covers what will happen if either the lender or borrower dies.
There are website services to help with this, like LawDepot, which offers a free draft promissory note that sets out the relevant details of a loan. Once filled out, this note can be taken to a solicitor who can act as a witness to signatures made by the borrower and lender.
There's a template loan agreement here, which can be used in a similar manner.
Another option could be using a semi-formal lending service like Agree It, which allows people to lend to friends through Facebook. Although, again, there is no legal obligation for them to repay.
If in doubt, it can be worth obtaining advice from a legal advice service. Some free advice centres, such as Citizens Advice or community law centres, may be able to offer pointers.
2. Tax implications
It's also worth noting that there are tax implications for informal lending.
If a lender receives any interest on a loan, then they must inform HM Revenue & Customs, as this amount may be liable for taxation as income.
Lenders must declare the received interest on their self assessment form as a taxable form of income. Loans that are interest free do not require the recipient or the benefactor to pay tax.
If a sum of money is given as a gift, rather than a loan, then it is free from inheritance tax up to the amount of £325,000. This is only true if the donor lives seven years after the payment is made.
Exceptions to this rule are that a person can give up to £3,000 per year without paying tax and up to £5,000 if the money is given as a wedding gift by a parent to their child.
3. Alternatives to family loans
All in all, the potential for future misunderstandings and the legalese required means that borrowing from a friend or family member can sometimes be more trouble than its worth.
Much research on this topic suggests that many of those who are considering an informal loan can't access good quality deals, or any deals, in the formal borrowing sector it may be worth looking more deeply into the market.
Peer to peer lending sites, such as Zopa and RateSetter, allow those with money to lend to those seeking to borrow, for example.
Lenders set their own interest rates and choose how long they are willing to lend their money for.
To reduce the risk of defaults, borrowers are subject to stringent checks. As a result, more than 75% of those who apply are turned away although social lending still has risks.
Credit unions may also be able to help.
In these cooperatives whose members have something in common, such as a place of work or a residential area, members pool their savings, allowing individuals to benefit from low interest loans.
Finally, there is a UK lender called Amigo loans that gives out borrowing to people unable to get credit elsewhere by asking for a guarantor, a friend or family member, to agree to repay the borrowing if the borrower defaults.
The lender does charge interest, however, and at fairly high rates: around 50% APR in most cases.
How much are we borrowing informally?
Figures suggest that the economic downturn has resulted in ever more loans being made between friends and family members.
In August 2011, an Aviva survey found that 63% of people had seen an increase in informal lending. More recently, in 2016 debt charity StepChange reported that more than a quarter of its clients, around 28%, owe money to loved ones.
Informal lending seems to be particularly rife amongst parents and children. National Debtline reported at the end of 2016 that around 67% of 18-24 year olds are now borrowing money from family, owing an average of £2,248.
While the "the bank of mum and dad" seems to have become the most popular source of loans for deposits for young people wishing to get onto the property ladder.
Unfortunately, an increase in informal lending is likely to lead to an increase in legal wrangles between people.
In December 2011, a Small Claims Court ordered a woman to repay £228,000 she'd made from the sale of an antique Chinese vase.
A vase might not be a loan in the traditional sense but the case had all the hallmarks of an informal borrowing dispute: the case was bought by the woman's ex boyfriend's mother (got that?) who said she had only lent the vase out; the woman argued it was a gift.
So whilst informal lending remains necessary and your instincts are to trust family and friends, it's still important to exercise caution and prudence when making such arrangements.