A FAMILY LOAN may sound like a good idea: one party receives interest income while the other may get a better interest rate, but is it? Whether you are the lender or the borrower, there are certain factors to keep in mind before you enter into an agreement. Here are our suggestions:

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For both

Check with your advisers These could be lawyers, financial planners and accountants. Each party might consider having his or her own adviser to represent their interests. Advisers can provide insight on the loan structure as well as any gift or income tax consequences of the transaction. For example, whether the interest expense is deductible or whether the interest received is taxable.

If the loan is interest-free, there might be complications. The IRS may require the lender to pay taxes on an “imputed interest charge.” This is the amount of interest that the IRS thinks the lender should have received on the transaction.

Borrowers usually have to repay the debt per the agreement. If they don’t, the cancellation of debt may be required to be reported as income on their tax return.

If the borrower or lender is married or has a life partner, it is a wise decision to include both partners when having these discussions. In this way, everyone involved will have a clearer idea of the transaction and what to expect as time goes on.

Put the terms in writing The note should detail such basics as the interest rate, term, payment schedule, late fees and collateral. Are there provisions for the borrower being injured or disabled?

Discuss defaults

It is best to discuss in advance what actions will be taken in the event the loan cannot be repaid.

Record mortgage debt This potentially allows the borrower to deduct the interest on his or her tax return. In the event of nonpayment, it helps make foreclosure a possibility.

Administration

Both parties need to continually monitor the loan throughout its life. Consider using a third party to administer the loan. This will reduce the time spent by the lender and, as a third party is involved, might provide an additional impetus for the borrower to repay.

Treat the loan in a business-like manner Evaluate the loan from a business perspective. Home loans secured by the related property may be a good deal. Loans to start a business are inherently more risky and require more evaluation. Loans to repay other loans aren’t such a good risk either.

For the lender

Don’t lend what you can’t lose

Even with the best intentions, the loan might not be repaid.

Credit worthiness. Can the borrower repay? It is a good practice to establish the solvency of the borrower and document it. Reviewing a credit report might be a great start. Sometimes it is better to just say no before lending than trying to resolve difficulties after the borrower has ceased to pay.

For the borrower

Money management

The loan might help you get back your feet. It is a good time to evaluate your entire financial picture and debt management skills. Seek counseling if needed.

Additional scrutiny

The lender is probably going to be more aware of your activities. You might be asked why you took a vacation instead of making a loan payment. Once again, consider your entire life.

Credit history

Chances are your family member isn’t reporting your loan payments to the credit bureaus. Paying off a family loan might not do anything to help your credit history.

Above all else, your relationship is the first priority. Missed payments and strained holiday dinners aren’t good for any family. Before entering into a loan transaction involving family members, make certain it is good idea for all.

Marc A. Hebert, MS, CFP, is a senior member and president of the wealth management and financial planning firm The Harbor Group of Bedford. Email questions to Marc at mhebert@harborgroup.com. Your question and his response might appear in a future column.