How Families Can Lend Money to Each Other Without Straining Ties

Parents and grandparents often want to help children and grandchildren reach major financial goals, such as buying a home, launching a business or paying down costly debt. To avoid misunderstandings, it helps to set clear repayment terms from the start.

A family bank arrangement can work much like a traditional loan, while allowing relatives to agree on interest rates that are far lower than what commercial lenders usually charge.

What is a family bank?

A family bank is not an actual financial institution. Instead, it is a structure that allows relatives to lend money to one another at rates below those offered by commercial lenders. Because the setup can carry tax consequences, families often bring in professionals. The arrangement can also help pool money for down payments, college costs and other large expenses.

The money borrowed through a family bank is not a gift. It still has to be repaid over time, which means records and documentation are necessary. While these setups are often used in estate planning, families with fewer assets can use the same approach.

How to keep a family loan from becoming a tax issue

The IRS publishes applicable federal rates, or AFRs, which set the minimum interest rates for certain private loans, including loans within families. The minimum rate depends on whether the loan is short-term, mid-term or long-term. If the rate is too low, the IRS may treat unpaid interest as imputed interest, which can raise the lender’s taxable income and create gift-tax complications.

Interest is generally taxed as ordinary income, while principal payments are not. It is wise to check AFRs before finalizing a loan because the rates are updated monthly. For larger family loans, working with a tax professional or estate attorney can help prevent problems later.

How to protect the relationship

Family loans can save parents significant money while giving adult children access to the funds they need. Even so, tax issues are not the only concern.

Families should plan carefully to reduce the risk of resentment. Every detail should be written down clearly, including due dates, payment schedules and penalties for late payments.

Adult children should also agree to automatic payments so the lender is not left chasing money personally. Some family loans include terms for what happens if the lender dies, the borrower divorces or someone asks for the loan to be forgiven. Parents should also think carefully about whether they can afford to lend at all; those who need their savings to last through retirement may want to avoid lending to children or grandchildren.