ABC's Of Borrowing From Friends & Family

by DCU |

Do you have a passion you want to fulfill by borrowing money? Borrowing money from friends, family, a family business, or trust is a real and serious commitment and must be managed responsibly.

Why would I borrow from family or friends? 

There are many good reasons to borrow from family and friends. The following are a few examples:

  • Buying a home
  • Buying or repairing a car
  • Getting a college or technical education
  • Lowering your monthly payments (debt-to-income)
  • Loan to a family business
  • Medical procedures
  • Supplement an existing bank loan
  • Home improvements
  • Consolidating credit card, personal, or education loans

If I have a good reason to borrow, what do I need to know?

Be prepared to answer some basic personal and financial questions about your loan request. Be honest and straightforward with your answers.

  • How will I use the money?
  • How will I pay back the loan?
  • What are my personal income and expenses?
  • If I am borrowing for my business, what are my business income and expenses, and do I have a written business plan?
  • Am I offering collateral as security for the loan?
  • How will this loan help me achieve my personal or business goal?

Now that you have a little more information, are you willing and prepared to take the next steps?

Why do I need the loan? How much money do I need?

Approach borrowing from a family member or friend the same way you would approach a credit union or bank. Start a loan application. Writing the answers to the following questions will get you started in the right direction:

  • What is the purpose of this loan?
  • How much money do I need to borrow?
  • How many months do I want to make payments?
  • Where is the loan repayment coming from?
  • If I am late making payments, what is a fair late fee?
  • Can I offer any collateral?
  • How often am I going to make a payment?
  • What interest rate am I willing to pay?
  • What monthly payment can I afford to pay? 

How much can I afford to borrow?

Debt-to-Income ratio

This ratio is a common way to understand if someone can afford the payment on the new loan. You add all your current monthly payments to the new loan payment then divide the total by your monthly net income (your net pay or “take home” pay). Total payments should include all loan payments, credit cards, car loans, other loans, housing expenses, mortgage payments, property taxes, interest, insurance, and condo or neighborhood association fees. Here is the formula to calculate Debt-to-Income:

X = total monthly payments

Y = new monthly loan payments

Z = total monthly income ( X + Y ) / Z = Debt-to-Income

How do I use my debt-to-income ratio?

Lenders have different requirements, but a debt to income ratio of 35% or less is preferred. Once you calculate your debt-to income ratio, you can use it as evidence to justify your loan request and your ability to repay the loan.

One of the benefits of a private loan is a family or friend lender might be more willing to advance money with a higher debt-to-income ratio than a bank. Knowing your debt-to-income ratio demonstrates that you understand how to borrow and will likely help your lender make their decision to make you a loan.

Can I reduce my debt-to-income ratio?

Yes. Here are some ways you can reduce the amount of your monthly obligations:

  •  Refinance existing loans at a longer term or lower interest rate so payments are smaller
  • Consider paying off debt by making extra principal payments and postponing any major purchase
  • Don’t add new debt – purchase by cash or debit card
  • Consider using layaway programs
  • Reduce expenses through conservation – turn off lights, turn down your heat, save water
  • Choose less expensive cable TV or mobile phone plans
 

No matter what you plan to borrow for, understanding how debt and income work together will help you make great borrowing decisions your entire life!

Private loans can help with financial goals

 

Private family loans can help with making financial gifts and transferring assets between family members. Consult with your Certified Public Accountant, estate planner, or tax attorney to learn how this can work and how these arrangements can be made. 

Conclusion

Making a loan to a family member or friend can be a viable investment option for people with the capital and willingness to help others. As a family and friend lender, you have an opportunity for a quadruple benefit:

1. Your loan directly benefits a family member or friend or the business they own,

2. If you choose to charge interest, you have the opportunity to earn an interest rate that can be better than you can get on your savings,

3. Depending on the rate you both agree to, the borrower could receive financing at a lower interest rate than they would otherwise pay, plus

4. The good feeling of knowing you’re helping someone important to you.

 

Any lending activity must be done following the rules of the state in which you live. Find local legal counsel to provide you advice when making a loan.  Use software from companies like www.ZimpleMoney.com* that provide tools to manage family and friend loans and other financial agreements. Be a responsible lender, and more importantly, a responsible borrower.

For more information, visit https://www.dcu.org/loans/friends-family.html.


*A service powered by ZimpleMoney, DCU Friends and Family Lending platform. Digital Federal Credit Union (DCU) and ZimpleMoney do not provide tax, legal, accounting, or personal financial advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for: tax, legal, accounting, or financial advice. You should consult your own tax, legal, and financial advisers before engaging in any transaction. DCU has negotiated discounted fees for our members using the ZimpleMoney.com platform. Details will be available after you register.

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