What's the Best Way to Handle a Family Loan?

Dear Carrie,

My daughter has been out of work for a year, and has asked me to lend her $15,000 until she can get back on her feet. I think I’m in a position to spare the money now, but will definitely need to be paid back by the time I retire in three years. Can you advise me on how best to help her out but also look out for myself?

—A Reader

Dear Reader,

This is an interesting question because it calls on you to listen to both your heart and your head. On the one hand, I can appreciate your desire to help your daughter through a rough patch because that’s what caring families do for each other. On the other hand, it’s essential that you also think through the practical implications for your own financial security. After all, the last thing you want is to become financially dependent yourself, especially as you approach retirement!

Let’s take a look at some things to think about—and do—before you make this important decision.

Carefully examine your financial situation

Before you do anything else, take a long, hard look at your own finances. Do you ever struggle to pay your bills each month? Do you have an ample emergency fund and sufficient insurance coverage to assure you'd be able to weather a setback of your own?

To be secure, I recommend you maintain enough savings to cover a minimum of three to six months’ worth of essential expenses. In addition, make sure you have adequate health and disability insurance to cover you in case an illness or accident keeps you out of work. Think through these issues carefully before you write a check.

Decide how much you can afford to lend

If you're convinced you're in a position to loan your daughter money, do a gut check on how much you can afford. If it turns out you can only manage a smaller amount, don’t feel guilty. Your daughter is fortunate to receive any funds that you can safely spare.

Create a formal loan document

Once you’ve decided on an amount, it’s important to write up a formal loan document. Because you’re lending money to your daughter, you might think you can simply write a check and call it a day. Unfortunately, though, unless you have a signed written document with a fixed repayment schedule and minimum interest rate, things can get complicated with the IRS. Documentation also gives you the ability to deduct an unpaid loan on your income tax return if for any reason your daughter can’t pay you back.

You don’t have to charge market rates, but you do need to set an interest rate at least equal to what the IRS refers to as the “applicable federal rate” (AFR). This is especially important if the loan is over $10,000. Otherwise, you could get hit with having to pay taxes on the “imputed interest” you never received. (The tax implications of imputed interest can be tricky; check with a tax advisor if you're unsure about how to proceed.)

AFR rates are quite low compared to commercial rates, which should make repayment much more doable for your daughter.  As the lender, you will report any interest you receive as taxable income, and your daughter may be able to deduct interest expenses on her tax return.  AFR rates are set monthly and vary on the type and term of the loan; you can find them at IRS.gov. 

Keep accurate records

Once the loan comes due, be sure to keep accurate records of every payment. If your daughter misses a payment, it’s important to document that as well. If at any time you're unsure of interest charges or the balance due, consult with an accountant who can help you stay organized and on top of all the necessary details.

Clearly communicate your expectations

And now we can get back to the personal side of things. It’s clear you want the best for your daughter, so if you decide to go ahead with the loan, tell her that. Explain your very real concerns for your own financial well-being so that she understands how important it is for her to pay you back in full and on time. Ask her if she has any questions or misgivings so that everything is on the table.

Your daughter is fortunate to have such a supportive parent. By lending her money now, you're not only helping her through a tough time, you're also expressing your confidence in her ability to bounce back for a stronger future.

Have a personal finance question? Email us at askcarrie@schwab.com. Carrie cannot respond to questions directly, but your topic may be considered for a future article. For Schwab account questions and general inquiries, contact Schwab.