Factors to Consider When Taking Out a Business Loan from a Family Member

The family bank always comes in handy when all other avenues seem dark. Sometimes it’s the first door to knock on when seeking funds to expand your business. Various reasons make a loan from a family member more appealing than a traditional loan.

First, there are few drawbacks. Then there’s the affordability in the rates and more lenient terms. Also, they may cut you some slack if you miss some payments. While all this sounds appealing, there are other factors to consider when going down this road. 

Take a look at what you must consider and whether the loan is worth the trouble.

  1. Chances of Approval are High

Banks and other lenders will insist on a stringent underwriting process to gauge your trustworthiness. On the other hand, a family member will likely be lenient with you. However, this is not to mean they won’t go through your business credit and your business plan, but the bottom line is their process is nothing compared to other lenders.

For example, for a bank to approve your business loan application, they’ll have to go through multiple factors including both your personal and business credit scores not to mention that you must have been in business for at least two years, the longer the better. 

After that starts the waiting game that may take months as the lender scrutinizes other factors including cash flow and existing debts. In contrast, you’re likely to get a nod from a family member in a fraction of the bank’s time courtesy of the personal connection you share. Therefore, if you need quick cash and don’t have good credit, the family bank may be your best bet.

  1. Get Better Terms

Even after you get approved for a business loan at a bank, you’ll have to deal with high interest rates. It could get even worse if you have poor credit. On the other hand, if a family member extends a loan, chances are you’ll get reduced rates no lender will think of giving you up to 10000 loan no credit check

In fact, they’ll be so low not even an SBA loan will be able to offer. They may be the most popular loans among small businesses but even their interest rate starts at 7.75%. Often, you’ll have a sit-down with a bank agent to discuss the terms of the loan. 

This includes how much you need, the interest rate (sometimes non-negotiable depending on your credit), and the repayment period. With a family member, you can agree on all these factors in a way that makes economic sense for you. Yes, traditional lenders will also offer you affordable terms, but it’s always to their advantage

  1. How Do You Want it? Equity or Debt

Borrowing from a family member doesn’t get any sweeter than this. You have the option of choosing what type of funding you want—something that’s not available at a bank. For the bank, you only have a single option, and that’s debt financing. That is where you borrow money to expand your business and then pay it back as debt as agreed

. The other form of financing is known as equity financing. With this method, the funding will come in as investment similar to how venture capitalists and angel investors work

Often, you’ll have to cede a certain stake of your business depending on the size of the investment. This means the family member will have shares in the business, meaning they may also weigh in on business decisions. 

However, you have the liberty to decide which route to take. For example, if the family member in question already has some years of business experience, it would be wise to have them at the table to help in decision-making and advice going forward. On the other hand, you can decide to maintain 100% ownership by limiting their involvement in the business because of their capital injection.

  1. Formalizing the Loan

Yes, there’s a need to formalize a business loan, even from a family member. It may seem too professional for an agreement between family members. Besides, there’s a verbal agreement that clearly defines the rules of engagement, right?

Wrong! Many people skip past this crucial step, yet there are key reasons not to:

  • Nobody takes the other for granted: You wouldn’t dare make late payments or neglect any other responsibility if you took out a bank loan. Why? Well, there’s a formal document that binds you to the terms of the loan. The same reasoning applies to a loan issued by a family member. By drafting a formal agreement, both parties will respect each other and will avoid a fallout.
  • Financial responsibility: Borrowing from a family member allows you to bypass a lot of strict rules imposed by banks. To avoid taking advantage of your family member and to ensure financial responsibility, it’s important to have a business plan that shows the roadmap you have for the business. This includes how much you need, and the repayment schedule.
  • Avoid tax issues: If a family member or friend loans you a huge amount of money, prepare to deal with the IRS. We’ll get in-depth on this a bit later.

The items that must be in the agreement include the principal amount loaned, the interest rate, the time, collateral involved if any, and the investor’s role in the business. If both of you don’t have any experience drafting such an agreement, consider calling in a legal professional and an accountant.

  1. Tax Implication on Family Loans

Earlier on it was stated that one of the reasons for drafting an agreement is the tax implication on family loans. According to the IRS, you’ll have to pay taxes on any amount above $13,000 if it’s a gift with no intention of repaying the loan. 

Also, the interest charged on the loan (if the family member decides on that) must not be under the market rates – not under 1.78%. This will prove that you’re in a legitimate business transaction.

However, if your family member decides not to charge any interest on the loan, the amount in question must not exceed $100,000. Exceeding this amount will invite the IRS to charge imputed interest, that is taxing them as though they were getting interest on the loan. 

Also, drafting a loan agreement will give the lender a chance to write off any losses if the business doesn’t succeed.

  1. The Tough Balancing Act

Again, asking for a loan from a family friend puts your relationship with them at stake. For some people, this is a normal transaction because they know how to balance the professional with the personal. However, for many others, keeping it strictly professional is the best route to take. 

Balancing the personal and the professional is quite easy. All you have to do is update the lender of the progress in the business to avoid any surprises.

Final Thoughts

Getting a business loan from a bank is difficult, especially if you’re a startup. Family members offer an alternative source of funding to expand your business and the best part is this type of financing is flexibility and affordability. On the other hand, this move can be a time-bomb waiting to blow up your relationship along with the business.

Therefore, to stay out of harm’s way, it’s important to do your research just like you would in any other business decisions. Don’t take the transaction lightly because you’re dealing with a family member. In fact, don’t be surprised if the whole process turns out to be more difficult than taking out a traditional loan.

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