Is Borrowing Money From Family the Best Approach?

From time to time, even the most diligent savers may need a financial boost. Large purchases like a new home or a car can sometimes require more cash than you have on hand. Borrowing money from family or friends is one solution, but it may not be the best option. As with every financial decision, you'll need to keep your long-term goals in mind and take steps to place you in a better position when future borrowing needs arise.

What to consider

Although borrowing money from family or a friend may appear to be the easiest and fastest solution when you're in need of a loan, there are several potential downsides to consider. This type of financial transaction will likely affect your relationship to some degree. Before borrowing money from family or someone you know personally, it's important to consider the consequences for each of you, as they can be lasting and potentially damaging.

Strained relationships

Talking to your family about money may cause tension, especially when everyone is at a different financial stage in their life. When you borrow from family members, they'll know more about your money situation than you might otherwise choose to divulge. This may add a degree of discomfort to future conversations involving spending and saving.

Shifting expectations

Taking out a loan from a parent or sibling may also set new expectations among family members. Other relatives may also want to ask for assistance, which may strain the finances of the lender. Parents may feel obligated to help their children and not want to admit their own financial strain when offering monetary assistance.

Lack of credit history

When you borrow from family, you won't find anything on your credit report to show your good repayment habits. This lack of credit history could hurt your chances of securing credit in the future. If you can't present a clear financial picture of your ability to make timely payments, lenders may not feel as comfortable extending loans to you.

Tax implications

If you're thinking about borrowing a large sum from a family member and paying little or no interest, it may be wise to consult a tax professional for advice. According to the IRS, the difference between the interest you would have paid at the market rate and the actual interest you paid your relative, if any, may be considered a monetary gift. Currently, amounts under $15,000 are exempt from gift tax.

Consider a bank loan instead

A bank loan can help you build an official credit history by giving you an official transaction that is reported on your credit report. If you apply for a larger loan, such as a mortgage, an established credit history can help you get approved. To this end, bank loans may offer certain advantages over a loan from a family member.

Build good financial habits

When you're repaying a loan, you'll get into the routine of setting money aside for payments. This can help you develop a monthly budget. When the loan is paid off, you may wish to continue to hold this amount each month and save for a large future purchase.

Improve your credit score

Your on-time payments will be reported to the credit bureaus and factored into your credit score calculation. If you handle a smaller loan well, this can lead to approval for larger loans in the future, which you may need to purchase a house or car.

Avoid straining relationships

When borrowing from a bank, the terms will be spelled out in a written and signed agreement, while dealing with family members can be a less formal process. A friend or family member could offer to help you, but when the time comes for you to request money, they may be unable to provide it. Borrowing from a bank avoids the resulting strain on relationships.

How to handle a loan from a family member

If you choose to borrow from family, you can take steps to avoid some common pitfalls. Maintain documentation about the loan, such as a signed loan agreement or bank records. Set up a formal payment plan, and stick to it. As the loan is repaid, document the process with check copies or deposit slips. This may help set good payment habits for the future while still benefiting from a safety net.

Before asking a friend or family member for a loan, it's important to consider all of your options. A personal loan from a bank might be a more suitable alternative when you're trying to build credit, avoid any strain on your relationships or prefer to have the terms of a loan documented in a formal agreement.