Creating a Proper Private Loan Agreement

Borrowing from family doesn't absolutely mean a verbal or unstructured written agreement. But it's better over the long term if there's formality involved because both the borrower and lender will receive the tax benefits they're entitled to. Also, a detailed document — prepared with the help of an attorney — can lay out specific scenarios if either the borrower or the lender has to break or alter his agreement.

This is why it's wise to consult a qualified real estate attorney or a financial planner before you even make the overture to your friend or family member. These experts can lay out the pros and cons of a personal loan arrangement as it affects your particular situation (either as lender or borrower). Professional guidance can also alert you to specific laws and requirements in your state you may have to follow if both borrower and lender are going to derive tax advantages from the agreement. (For more detail on how to locate and hire a financial planner, see Chapter 2.) To find an attorney, it's wise to go to trusted friends for a referral or to go to your city or state's bar association.

There's no reason why a lender has to settle for a lousy deal just because she's related to the borrower. In the case of close relatives, many lenders, particularly retirees, can be happy with a rate that exceeds what they could get in the highest-rate bank CD. The borrower gets a bargain, and the lender gets a better deal than she can get from the bank and still have the security of real property behind the loan.

Before you select an attorney, search in three legal specialties: real estate, tax, and estate planning. Not only will your attorney need to know about real estate agreements and their tax consequences, but depending on the relationship between you and your lender, there may be an estate issue involved (particularly with parents and children). You want the loan agreement to be in full compliance with IRS rules as well as the lender's estate situation if that's an issue.

If you have two to three candidates to interview as legal counsel, make sure you ask them the following:

  • Have you ever put together a private loan agreement before? What's involved?

  • Can you advise us on any tax issues we should discuss with our tax advisors?

  • What would you charge us to set up this agreement versus doing it ourselves?

  • It is possible to do these loans on a handshake or a promissory note (as in the following example), but it always pays to get trusted help in a complicated financial situation.

    A Sample Promissory Note

    Depending on the situation, any loan agreement can contain its own specific features. The following text is for general illustration only. It should not be seen as a final agreement.

    PROMISSORY NOTE

    Borrower: Earl Jones of 202 Jones Street, Anyplace, USA (Individually and collectively the “borrower”)

    Lender: Lisa Jones

    Principal Amount: $10,000.00

    • FOR VALUE RECEIVED, The Borrower promises to pay to Lisa Jones at 202 Jones Street, Anyplace USA, or at such address as may later be provided in writing to the Borrower, the principal sum of ten thousand ($10,000.00) USD, with interest payable on the unpaid principal at the rate of 4.0 percent (4%) per annum, calculated yearly not in advance.

    • This Note will be repaid in full 5 years from the execution of this Note.

    • At any time while not in default under this Note, the Borrower may pay the outstanding balance then owing under this Note to Lisa Jones without further bonus or penalty.

    • This Note will be construed in accordance with and governed by the laws of the state of New York.

    • All costs, expenses, and expenditures included, and without limitation, the complete legal costs incurred by Lisa Jones in enforcing this Note as a result of any default by the Borrower, will be added to the principal then outstanding and will immediately be paid by the Borrower. In the case of the Borrower's default and the acceleration of the amount due by Lisa Jones, all amounts outstanding under this Note will bear interest at the rate of 5 percent per annum from the date of demand until paid.

    • This Note will ensure to the benefit of and be binding upon the respective heirs, executors, administrators, successors, and assigns of the Borrower and Lisa Jones. The Borrower waives presentment for payment, notice of nonpayment, protest, and notice of protest.

    IN WITNESS THEREOF Earl Jones has duly affixed his signature under seal on this 4th day of July, 2007.

    Generally, any private mortgage transaction includes a promissory note that establishes how the debt will be repaid, and a mortgage or deed of trust statement (depending on the state you live in) that secures the property as collateral for the promissory note. It basically says that if you don't fulfill all the terms in the agreement, the lender has the right to foreclose on the property. In the case of a private mortgage transaction, there needs to be a transfer of the title to the property as part of the process. As part of the transfer, the following documents will need to be part of the record as the property is transferred:

  • A deed that transfers the property from seller to buyer

  • Required documents from local, state, and federal offices, such as transfer tax forms, certification of smoke detectors and absence of lead paint on the premises, seller documents, and legal description of the property

  • A written document is a sensible way to handle such an arrangement. Get the best advice on both terms and the actual writing of the agreement.

    How to Start the Conversation

    The best time to ask parents, other close relatives, or friends for a loan is not at the holidays or at any other family gathering. Such settings are full of distractions and prying eyes and ears. It's better for one side to raise the idea over a cup of coffee or during a phone call outside the home or office. But the conversation in which you raise the idea shouldn't be the one in which everything gets settled.

    According to Circle Lending, a Web-based company that helps family and friends formalize personal loans, about 14 percent of personal loans end up in default, compared to a roughly 1 percent default rate for bank loans.

    As mentioned, families may like the idea of a personal lending agreement because it's a good way to keep money inside the family. Relatives get to help family members or friends through a tough time, and the borrower gets the same benefits as any other homeowner, albeit at a more affordable rate and/or an easy approval process.

    This approach can be particularly helpful to friends and family members who have struggled through a bankruptcy or a recent job loss and are only starting to get their cash flow in order. Particularly in the case of bankruptcy, borrowers face big hurdles from lenders. A successful, provable payment record with a private loan can also be applied to future lending efforts. For the most creditworthy customers, closing costs on a mortgage can average between 3 to 6 percent of the total borrowing cost, and if the borrower is credit-challenged, the cost of a commercial loan can go even higher.

    So consider the thousands of dollars in savings and the ability to accrue equity without the need to ever go back into the commercial market. With the right loan agreement, it's a great deal for a struggling borrower.

    What happens if my siblings hear about the loan my parents are giving me?

    Ultimately, it's your parents' decision whether to inform your siblings, but in most families, full disclosure is the best policy. Many parents try to split things evenly between the children to avoid bad blood. So if they make this loan, you both might agree to give you less of an inheritance if your loan is not paid completely at the time of their death. This is why private loans are a relevant topic of discussion with estate attorneys.

    If both sides are willing, then it's a good idea for the borrower or the lender — whoever began the conversation — to start pulling together a formal proposal either alone or with the help of a financial planner and attorney. That proposal should be in writing and include the following elements:

  • Target amount of the loan (good to have in mind before being ready to buy a certain property)

  • Description of the property

  • Proposed terms, including interest rate and term of repayment

  • Discussion of why this arrangement should be a loan instead of a gift and what that would mean with respect to taxes for both parties

  • What happens if the loan terms are broken

  • Area for both parties to sign

  • In order for a transfer of private money to be considered a mortgage loan and not a gift, the lender must charge an interest rate at no lower than the minimum rate required by the federal government, called the Applicable Federal Rate (AFR). If the lender charges less than the AFR, the IRS may view the interest as a gift and not a loan. To find out what the current AFR is, go to the IRS Web site at www.irs.gov/taxpros/lists/0,,id=98042,00.html.

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