Pros and Cons of Accepting Loans From Friends and Family

Almost every new business requires some sort of outside funding to get off the ground. If you’ve ever launched a business, then you know how difficult it can be to secure that funding. Young business owners in particular may struggle to get loans without a sufficient credit history. As a result, many entrepreneurs turn to their family and friends for help.

While borrowing from people you know allows you to launch faster with fewer hurdles, the process is not without significant riskss. By doing your research and taking positive steps to be ready to make a funding request, you can make an informed decision regarding both your business and your future relationships with loved ones.

Pros

Here are some of the advantages of turning to friends or family members for a business loan:

Flexible Options

Entrepreneurs and those with poor credit may struggle to secure a loan through traditional means. One of the benefits of borrowing from loved ones is that you don’t have to jump through the same financial hurdles to be approved. Because they are eager to help you achieve your goals, friends and relatives will often lend to you in cases where banks would not.

Additionally, private lending from friends or family can allow for more flexible repayment schedules. For example, you can set up a grace period that allows you to halt payments while your business is getting off the ground. As an added benefit, borrowers may have the option of ceasing payments if their business hits a rough patch, something that traditional lenders will rarely permit.

Lower Interest Rates

Because of the inherent uncertainty of small businesses and startups, banks tend to charge higher interest rates on loans for newer businesses than for more established companies.

As such, one of the benefits of borrowing from friends and family is that you can typically land a lower rate. Not only does this reduce your overall debt level —which can boost long-term credit for your business—but it also enables you to invest more of your hard-earned cash back into the company. Investing money back into your business may help you grow faster and–perhaps– pay off loans more quickly.

Lender Benefits

Of course, borrowers aren’t the only ones who can benefit from a private lending arrangement. The savvy lender can often earn money by investing in your business, provided he or she understands the potential benefits and pitfalls of investing. Along with the satisfaction of helping a friend or family member in need, investors may enjoy being part of the business-formation process while earning returns similar to those provided by other investment vehicles.

Cons

Despite the many benefits to investors and lenders, personal loan arrangements can be complex. Here are some of the social and financial ramifications of accepting a loan from a friend or relative:

Lack of Clarity

One of the advantages of personal loans is that they don’t require the same legal documentation as those provided by a bank or other lender. However, the lack of clarity can be detrimental if borrowers and lenders have different expectations.

For example, friends or family members who lend you money may assume their financial investment gives them a stake in the company or a voice in daily operations. On the other hand, borrowers may believe that it’s okay to miss the occasional payment since the lender is a friend. By carefully documenting all terms and conditions in advance, the parties involved can avoid misunderstandings.

Generally, it is a good practice for, borrowers to arrange for a business attorney to draw up a promissory note or similar document that outlines interest rates and payment terms, including penalties and late fees. Additionally, any documentation should stipulate what will happen if your business proves unsuccessful. Making a real effort to make sure that the person lendin gyou money knows all the possible risks and rewards of investing in advance can help you to avoid disagreements down the line.

Tax Issues

In their eagerness to help a friend or loved one in need, lenders may neglect to consider the effect a loan will have on their tax liability. Insufficient loan documentation can open up the involved parties to IRS scrutiny. Loans and gifts have different tax implications, so it is important to have any loans carefully documented.

To protect their interests, both borrowers and lenders should follow the steps traditionally taken by a bank or credit union when setting up a loan. Along with a signed promissory note, your loan documentation should feature a detailed repayment schedule and any other elements that ensure you are meeting all IRS requirements that govern private lending.

Social Awkwardness

Of course, accepting loans from loved ones isn’t just problematic from a legal perspective. Mixing business and pleasure can also complicate routine social interactions.

One of the disadvantages of owing money to loved ones is that it may open up unwanted dialogue about your spending habits. Whereas a bank won’t tell you to stop going out to dinner or discourage you from buying a new car, lenders who are also friends or family may criticize you for spending money =when you have yet to repay your debt. Setting clear payment terms and sticking to them can help borrowers avoid these uncomfortable moments.

Accepting a loan from a friend or family member may allow you to avoid banks and lenders while securing a lower interest rate. However, failing to set up clear and defined terms for repayment could be problematic for your personal relationships.. Taking time to make a solid plan and documenting your agreement formally can help all parties feel empowered and treated fairly.

For more lending options, see our article on the different types of business loans.