Anyone who’s thinking about extending a loan to a friend or relative should be familiar with a few important tips for loaning money. These precautions help protect the lender in case the borrower doesn’t pay the money back as promised or in case a disagreement arises about the terms of the loan.
Don’t Cosign a Loan
It may seem easier to cosign a loan for someone than to lend him money directly. When you cosign you’re simply signing your name to a document, and no cash leaves your hands. However, one of the main tips for loaning money is that you should avoid cosigning because it can harm your credit, as Real Simple notes. Cosigning makes you obligated to pay if the borrower doesn’t. And if you don’t realize the borrower is falling behind on payments and as a consequence don’t pay in time, your credit score goes down. Then your own ability to take out a loan or rent property is affected. It’s safer to lend money directly because this doesn’t threaten your credit.
Write a Contract
Disputes and late payment are more likely when there’s a misunderstanding about the terms of the loan. Prevent misunderstandings by writing a contract when you lend someone money. This contract should state how much money you’re lending and whether you’re charging interest. If you are charging interest, the contract should state how much. Also set a date by which the loan should be repaid, and specify how the borrower is supposed to make payments. For example, you could agree to let the borrower pay back the entire sum at the end of the loan period, or you could ask for monthly payments.
The contract should say how you will proceed if the borrower fails to pay. The consequence could be going to a third person for mediation or going to court; alternatively, you could simply agree that you won’t issue any more loans to this person in the future if he doesn’t pay what he owes you. Both you and the borrower should read and sign the contract, ideally in front of a notary who can certify your signatures. You can find notaries at banks or law offices. Getting the contract notarized helps protect you against claims that the borrower didn’t really sign the document. Make sure you sign and notarize two copies of this contract: one for you, and one for the borrower.
Find Out How Your Taxes Will Be Affected
If the amount of your loan is greater than $10,000 and you charge no interest or less than market rates, the government may view your loan as a gift, as Kiplinger explains. Forgiving the loan in the event the borrower isn’t able to pay you back also causes the loan to be considered a gift for tax purposes. Before you finalize the terms for a large loan, speak to a tax advisor to learn whether you’ll owe gift tax and how your tax bill will change as a result of the loan.
Finally, the most important protection is not to lend more than you can afford to lose. Keep the loan amount small enough that there won’t be any significant damage to your finances if you aren’t able to recover the money. Then you won’t have to worry about the outcome of the loan because you’ll know you don’t have too much at stake.
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