This article is written by Abhishek Sharma, pursuing a Diploma in Advanced Contract Drafting, Negotiation and Dispute Resolution from LawSikho.

Introduction 

Neither a borrower nor a lender be, for loan often loses both itself and friend.

A loan to a family member between relation by blood or marriage which may or may not be secured is called a family loan Agreement. It is also called Loan Agreement between family Members, Simple Loan Agreement Between family and Family or Family Loan Agreement Document. Traditionally in the earlier times, the terms and agreement of this agreement go undefined or hazy. Usually demanding such money back was a little difficult. In some situations, it even goes interest free. So, should we restrict ourselves from entering into a family loan agreement? But what about if you negotiate the family loan agreement by entering into a contract which clearly defines the terms and conditions in the agreement. This will be helpful in protecting your interest. 

Generally speaking, there are 2 major ways to do this – a promissory note and a detailed loan agreement. Both of these are legally valid documents and are accepted by courts. for promissory note, section 4 of the Negotiable Instruments Act, 1881 comes into picture.

This Article discusses in detail as to what exactly is a Family loan Agreement and helps the readers to effectively negotiate this agreement by keeping in mind the points mentioned in the article. The article also discusses the benefits, risks and vital points to be included in your agreement. 

Family Loan Agreement

A Family Loan Agreement can simply be defined as a legal document that is executed between relations by blood or by marriage. Family Loan documents are drawn on a stamp paper and notarized. It helps you design your agreement by putting clauses of your preference such as on collateral, default, termination and other rights. It is advised to use full names as appear on the identity proof and remember to mention the date and timing carefully. Keep in mind points such as tenure, periodicity of the payments and how much interest will be calculated (if any) should be phrased clearly. It is advisable to carry out transactions through a bank cheque. Also mention details such as cheque number.  

Unlike the Promissory note, loan agreement can also be modified by adding an amendment clause. Both parties mutually agree on terms and conditions. It is a good practice to get the document signed by a witness, preferably a neutral person not related to any of the two parties. 

Tax Angle

Gifts from a family member are not taxable, neither are loans. But if you receive a gift above Rs. 50000/- from a non-relative will be taxable under Income Tax Act. Imagine for a fact that if your friend or some relative gifts you Rs. 70,000/- you need to pay tax on the same, but in case it is a loan that you will be paying back, then there won’t be any tax on it. It should be noted that interest-free loans are not taxable for both the parties i.e., borrower and lender.  

Steps to use a Family Loan Agreement effectively

A family loan agreement should share and specify a repayment term and payment schedule, interest rate and other contingencies. Like any other agreement, this agreement should also include details such as full names address of both the parties, specifying their relationship. Notarizing your agreement is also a good option and recommended for legal purposes. 

For example, if your relative has a bad history of repaying loans to any financial institution, or he has been adjudged insolvent by any tribunal, he doesn’t have a good financial background, in such cases, it would be better not to lend money to such a person. If it’s very urgent, you can seek help from a guarantor, if any. 

Step 1 – Analyze Family Member

Before entering into this agreement, first ask yourself whether the person is honest, do they have a good track record of repaying debts and what is the reason for needing the loan. 

In case the family member does not pose any red flags after asking yourself such questions, the best thing you can do is to obtain the credit score and their credit report. You should use your intuition before giving the loan because if you have the money to burn, it would be better to gift money or not give it at all. 

Step 2 – Formalize an Agreement

Formalizing is an effective way to bind the other party to secure your payment. Generally, family loan agreement goes undefined on key aspects and many times it’s only orally done. To protect your interest, you can enter into an agreement by seeking help from an advocate which shall include inter-alia all the terms and conditions to secure your payment in future even if the person is adjudged insolvent.  

Key aspects to be included 

• Payment Schedule
• Interest 
• Repayment
• Expenses

Step 3 – Finalize and Sign

Before signing the agreement, it is advisable to sit down in the presence of two witnesses when coming to the terms on the agreement. After the documents are signed in the presence of witnesses, either present a cheque or make online transfer of funds. Do not make payment in cash. Although states also tend to set the statutory limit on the maximums of interest which can be charged on the loans, these are mostly irrelevant for family loan agreements. 

Things to consider when borrowing from Family

Mostly it is seen that the borrowers go to the family members after they have been refused by the other traditional lenders. This may be because of uncertain and insufficient earnings. The family loan agreement occurs outside the ambit of the formal financial system. Such borrowings do not build the good credit history of the borrower as it would have been built otherwise. 

For example, Aman was unable to get a loan from a Bank or any other financial Institution because he had a very low credit score and bad repayment history. He had insufficient earnings which further make it difficult for the lender to believe that he will repay the amount in future. In such a situation a family member should be very careful because the only option left with Aman is to ask a family member for a loan. He reflects less probability of repaying it back. 

Alternatives to Family Loans

The purpose of family loan is more of a support to the loved ones. There are other 2 ways as well besides lending money to them. 

• Gifting: It means when you give financial assistance to a family member without having any expectation of getting something in return.
• Co-Signing: You could also co-sign a loan that your family member takes out to help them get approved. Benefits and Risks of Family Loans.

Benefits and Risks 

A family loan agreement has certain benefits and may result in a win/win situation for both the parties. 

Benefits

• Mutually beneficial loan terms
• Lower interest rates
• Forbearance

Risks

• Damaged Relationships
• Non-Payment 
• Lack of funds Availability

Preserving the Family Relationship

It is advisable that before you move forward with the idea of lending money or even borrowing money from a family member, make sure to discuss the loan in detail. 

If either the borrower or lender is married (or in a lifelong relationship), both partners need to be involved in the discussion. In addition to the borrower and lender, think about anyone who is dependent on the lender—children or other relatives under the lender’s care, for example.

Consider this loan as other agreements and there is nothing wrong in being too detailed in these discussions. Afterall it is about finance which is important and having a few difficult and hard discussions is better than damaging the relationship permanently. 

Tips to protect the lender

From the point of view of the lender, he should take certain measures so as to minimize the substantial risks that they take when extending a loan to a relative. 

• Advice from a Local Attorney: You can seek the services of an attorney and disclose the material facts and discuss your risks and options to protect yourself.
• Encourage the borrower to safely deposit the funds: It simply means that once the lender has made the payment under the agreement, it is advisable that the borrower handle the sum of money in a very careful manner because you cannot request the lender to pay the sum again once it is lost. 
• Get it in writing: A written agreement is indeed important to keep both the parties on the same page and avoid any dispute in future. It ensures that the lender does not walk away empty handed. You can also look online for templates.
• Use collateral: Insisting on collateral is important and a helpful way to secure the loan. Getting collateral means you get hold of an asset by taking possession and sell it off in case the borrower fails to pay back in the worst possible scenario. Those are just a few things to consider—your tax adviser can tell you more.

Drafting a Loan Agreement

Consider following factors while drafting a Family Loan Agreement:

• The sum which you are planning to lend;
• Reason as to why are you lending the money;
• Expectation of getting repaid;
• In what manner you expect the payment to be returned;
• Interest rates;
• What if borrower defaults in making payment, any collateral for same; 
• Whether you will use a third-party loan servicer and whether it will report payments to credit bureaus;
• What if the borrower becomes unsound or any disability which stops him from paying back;
• If the loan will result in others (such as the borrower’s siblings) inheriting less and whether that will be taken into consideration upon your death.

Terms for Borrowers

It is advisable to the person who receiving the family loan (i.e., borrower) should consider the following aspects of the loan:

• Whether you have sufficient resources to pay back;
• Plan of action if not able to make payment for a month or few;
• Whether you plan to disclose to the lender the way you will utilize the funds proceeds;
• Whether the lender has the right to “suggest” how you prioritize expenses, choose a career, and spend your time (especially if you’re not making payments);
• How the lender will be affected financially if you’re unable to repay (because of an accident, for example);
• Whether you agree to build credit and have the payments reported to credit bureaus.

References

1. Chandralekha Mukerji, Money Today, January 2013, available at https://www.businesstoday.in/moneytoday/savings/caution-before-lending-money-to-family-member-or-friends/story/191074.html (Last Visited 16 April 2021)
2. e-Forms, available at https://eforms.com/loan-agreement/family/ (Last Visited 17 April 2021) 
3. The Balance, How to handle lending and borrowing with family, available at https://www.thebalance.com/family-loan-315551 (Last Visited 17 April 2021)
4. Debt.org, Loan Agreement with family and Friends, 26 February 2021, available at https://www.debt.org/credit/loans/friends-family/ (last Visited 18 April 2021)
5. Credit Karma, Family Loans, available at https://www.creditkarma.com/personal-loans/i/family-loans (Last Visited 19 April 2021)

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