Economic events of the past couple of years have made it more difficult for people to obtain conventional lines of credit, and as a result, many are turning to family members for loans for a variety of purposes.

An inter-family loan has its pros and cons. On the pro side, a family member is not going to check your credit. On the con side, if you default on this loan, it could seriously impair your relationship with the lending family member and other members of your family. And it could severely damage the lender’s finances.

Atlanta-based financial adviser Russ Thornton suggests the following:

I would highly encourage EVERYTHING be documented, countersigned by all parties, and have a third-party witness sign, too—maybe a CPA or financial planner. The documentation needs to state all terms (interest rate, payment schedule, term of loan, etc.) and needs to clearly state recourse if things go sour. Can the lender call the loan early—under what conditions? What if the borrower can’t make payments? Are there any penalties, and, if so, what are they? I think all parties should try to imagine all possible scenarios—good, bad, and ugly—and discuss and document how they would be handled.

While this may seem excessively formal, it is vital to treat any loan transaction among family members as an arms-length business transaction.

Here are some more tips for arranging a loan with a family member:

1. Use a promissory note, committing the terms to writing.Both parties should sign it. The promissory note should contain at least the following:

  • The loan amount
  • The repayment schedule
  • The rate of interest

A promissory note will protect both parties in any number of circumstances that may arise, such as if the loan isn’t paid back.

2. Charge a reasonable rate of interest. An interest-free loan is likely to be considered a gift rather than a loan and could result in the lender having to file a gift tax return. If the rate of interest is below the applicable APR (set by the IRS), the lender could face the prospect of having to declare imputed interest as income. Basically, in this situation the IRS will take the difference between the applicable APR and the charged interest and use it to determine the interest that should have been charged. This extra amount becomes income to the lender and taxes will be due, even though the lender has not received any cash payment of this extra interest.

3. Protect yourself in the case of a death with proper documentation. If your loan is undocumented and one party dies before the loan is repaid, you may face issues. For example, if the recipient of the loan dies before the loan is fully repaid, the lender might come after the recipient’s heirs. If nothing is documented, the heirs can deny that such an arrangement existed, and the lending party would be out his or her money. On the flip side, if the lender dies before repayment, the recipient might say the lender had indicated that the rest of the loan was to be forgiven in the event of his or her death. Again, without proper documentation, this would be hard to prove.

And, most important:

4. Do not lend money to a family member that you need yourself. We all want to help out a family member, but don’t do it if lending the money would jeopardize your financial security.

This article is not meant to be a primer on loans between family members. If you are contemplating asking a family member for a loan or making such a loan, please take it very seriously. Even though family is involved, treat it as a business transaction. If needed, consult with a financial or legal adviser who is versed in this area.

Roger Wohlner, CFP®, is a fee-only financial advisor at Asset Strategy Consultants in Arlington Heights, Illinois. Roger provides advice to individual clients, retirement plan sponsors and participants, foundations, and endowments. Follow Roger on Twitter.