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Personal loans need structure

Posted by Jill Boynton  May 22, 2009 10:08 AM

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As the unemployment rate climbs, so does the need of individuals to borrow money. Unfortunately it is not always possible to take out a bank loan. Banks are becoming tighter with their lending standards and reasons such as a poor credit rating or an already high debt load may prevent one from getting bank approval. In such cases individuals often turn to family or friends for a personal loan. This can be a good solution, but to work best the loan should be more than a handshake. Because of the personal relationship between the parties it is best to keep the loan at "arms length" - which means treating the agreement as if you were unrelated parties - to help prevent any misunderstandings.

Both parties should take steps to make sure the loan is fair and the terms are clear by creating a formal structure. At the very least the loan terms should be put in writing and signed by both parties. Without this document the IRS could argue that the loan is in fact a gift. The loan agreement should spell out the amount borrowed, the interest rate, the length of the loan and the amount of the periodic payment.

The lender doesn't have to charge an interest rate, but if the loan is a "demand loan" (payable in full at the lender's demand) then the difference between the rate charged and the Applicable Federal Rate (a rate set monthly by the IRS) is considered to be imputed income to the lender, and taxable at ordinary income tax rates. For instance if you lend your brother $10,000 for 4 years at 0 percent, and the AFR is 2.25 percent, the annual interest you didn't charge (about $200) is imputed income, taxable to you. (click here for exceptions to this rule.)

You can create an agreement yourself or there are companies that can do it for you, such as Virgin Money.

This blog is not written or edited by Boston.com or the Boston Globe.
The author is solely responsible for the content.

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ABOUT MANAGING YOUR MONEY
Local finance professionals share insights and advice on issues such as budgeting, managing debt, and retirement planning.

About the contributors

D. Abraham Ringer is a CERTIFIED FINANCIAL PLANNER practitioner and a Financial Adviser with Morgan Stanley Global Wealth Management in Boston. He is registered in MA, NH, NY and several other states to which his articles are directed. For more information please visit www.morganstanleyfa.com/ringer
Financial Planning Association™ of Massachusetts has 900 members who specialize in the financial planning process. Many of its members engage in philanthropic pro bono work in their communities, recommend legislation, elevate public awareness, promote financial literacy, and advocate for sound economic and tax policies.
Odysseas Papadimitriou is the founder of CardHub.com, a credit card and gift card marketplace, and WalletHub.com, a personal finance site. He has more than 13 years of experience in the personal finance industry, and previously served as senior director at Capital One.

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