Reuters Money

Paul Brock knew he needed a website to publicize, promote and market his artwork but he didn’t have the $1,000 in cash he needed to pay the web designer. So he turned to his brother, Ned, who often stepped in and lent money to Paul for out-of-the-ordinary or one-time business expenses.

“I am happy to help when I can,” says Ned, who works in financial services. Ned estimates the total amount he has lent Paul is around $10,000. But he figures that because each loan is only $1,000 to $2,000 and his brother always pays him back, he doesn’t need a formal agreement. So far, he’s been lucky.

Lending money to family members — whether you’re rich or poor — is fraught with emotional potholes that you don’t know exist when you provide or accept a loan with a business associate. There are a few guidelines that you can heed that may help diffuse the tension that may occur with such transactions among family members.

Assess the need
As Ted Beck, CEO of National Endowment for Financial Education (NEFE) sees it, there are three scenarios in which a family member might need a loan: co-signing for young college graduate without credit history; lending to a someone in debt; or making a loan to a family member without a job. As you can imagine, each situation will require you to think differently about each loan.

About 25 percent of people in a recent NEFE survey reported they had co-signed for a family member. “That is a high number,” says Beck. For those adult children transitioning to financial independence, it makes sense. It doesn’t assume that the co-signer will make the payments but it does mean that the co-signer has a debt obligation. “It is important that both parties understand what co-signing means — to help establish credit — and that the co-signer understands it goes on their credit score,” says Beck.

Lending to someone with a debt problem should be set up like a real loan with a transactional component complete with interest rates, repayment schedule, etc. Try to understand the person’s situation. “This is very high risk and before you lend the money you have to make sure you can afford it,” says Beck. Also note that the interest you accrue on the loan is taxable. You can use the applicable federal rate (AFR). That is the lowest interest rate you can charge someone.

Finally, lending money to a family member without a job is the toughest situation. “The person doesn’t have the ability to repay you,” says Beck. In this instance, you’ll need to think of the money as a gift rather than a loan. Internal Revenue Service laws allow you the ability to give someone up to $13,000 on an annual basis — tax free. After that, the next dollar is subject to gift tax that starts at 35 percent.

Determine the best strategy
Once you’ve got a handle on the type of situation, you’ll need to decide on the best loan strategy. Wealthier folks often provide investment lending or bridge loans to one another. These strategies are for much larger sums of money. “You also will need to decide whether you want to take collateral with a bridge loan,” says Drew Kanaly, chairman and CEO of Kanaly Trust, a wealth management firm. For extremely large sums there are firms that will actually do the mechanics of the loan for a monthly fee, that is collect the payments and move the money.

There is also an entire subculture of groups like those from Mexico and Latin American countries that practice rotating credit associations or lending/savings circles. It has different names all over the world: in Latin America, it’s called “the tanda,”  in the Caribbean it is called “sou-sou banking”.

In each instance, it is a group of 15 to 20 individuals who know each other through long-term neighborly relationships, religious affiliation or extended family relations. Each participant agrees to make regular monetary contributions to a fund that is then given in whole or in part to one participant at the end of the month in rotation. For these communities, “it’s really significant,” says Barbara Robles, senior research liaison at the Division of Consumer and Community Affairs, Board of Governors of the Federal Reserve System.

“Their entire financial transactions behavior is so far removed from the mainstream. They are very creative in having different kinds of safety nets and social capital that they can tap into,” says Robles. She also notes that the U.S. savings strategies are good for the long term but these lending circles are quite effective for short-term needs.

Create a contract
Regardless of what loan strategy you use, experts suggest that you always write the transaction down. “It is always best to do a contract,” says Ted Connolly, a bankruptcy lawyer in Boston and author of “The Road Out Of Debt: Bankruptcy and Other Solutions for Your Financial Problems.”

“The more you can put on paper and the clearer the terms are, the better — that way there is no confusion,” says Connolly. The contract should include the total amount of the loan, the interest rates, repayment schedule, and any other relevant information.

Just remember, no matter how well-scripted the transaction may be, you’re dealing with family — and that in itself can’t be scripted at all. Plan and hope for the best, but be prepared for anything.