Lending money to family members isn’t always a good idea. But in the right circumstances, such loans can benefit both sides financially, while allowing some wonderful qualities to emerge: trust, accountability and responsibility. Because interest rates are now at historically low levels, I thought I’d walk you through an example of why and how an intra-family loan makes sense.

Let’s start with the main reasons for doing intra-family loans, assuming your borrowers have a good plan for the money:

1. The borrowers avoid lending fees, which can be 2% or more of the loan amount.
2. The borrowers get a really good interest rate, especially if they have a weak credit history.
3. The lender ends up transferring wealth to the next generation, assuming the borrowers use the money wisely. This means investing the proceeds from the low-cost loan into higher returning assets, such as a house in an up-and-coming neighborhood, a promising investment, or to start a business.

If a Lender or Borrower You Be

What interest rate to charge? The answer is: the Applicable Federal Rate (AFR), shown below for loans made in March 2015. As you can see, the applicable rates are well below current market rates, even for borrowers with stellar credit. Subtract the lending and origination fees and the comparison gets even better.

Of course, you can charge less than the AFR at the time of the loan. But if you do, a portion of your loan will be treated (and taxed) as a gift.

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Really Low: Applicable Federal Rates (AFR)
March 2015

Source: Rev. Rule 2015-4, IRB 2015-10.

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To make this more real, here’s a situation where an intra-family loan would work well.

FOR EXAMPLE: Zack lends $400,000 to his grandson Billy, to buy a $480,000 fixer in an up-and-coming neighborhood. Term is 30 years, at 2.19%, so Billy’s monthly payment to Zack would be $1,517.17 a month. Had Billy borrowed from a bank, his monthly payment would be $370 higher (3.9% rate). It gets better, though. Zack doesn’t need the money, so he specifies interest-only repayments – just $730 per month. With the money saved on the mortgage loan — about $1,100 a month — plus his own savings, Billy fixes up the house and sells it in three years for $600,000.

The result: Billy has $120,000 in profits to invest in another house. Zack gets his $400,000 back plus a 2.19% annual return, lots more than the bank CD or money market he might have otherwise considered.

Note Well

Money transfers between family members are considered gifts, unless you have a documented creditor-debtor relationship. What does this mean? You need a signed written agreement with a fixed schedule for repayment. Some other things to keep in mind:

• The borrower should have the finances required to make the loan payments.
• The borrower may claim a tax deduction for home mortgage loan interest, but only if the loan is secured by the house.
• Both parties should keep accurate records of all principal and interest payments in case the transaction is questioned by the IRS.
• The lender can opt to forgive up to $14,000 annually in interest payments (maxing out his/her annual gift tax exclusion). However, although not actually received, the annual interest due will still be considered taxable income for the lender.