Understanding Personal Loans
One of my sons is going back to school full-time this month to get his MBA. While he did get a scholarship, it wasn’t for the full amount of tuition so…I put on my “Bank of Mom and Dad” hat and offered to help with a personal loan for the next two years of tuition. Borrowing from or loaning to family members can be complicated. Here are some rules and recommendations:
- Most personal loans are “unsecured” which means all I’m relying on from my son is his promise to pay me back. If I said “I want the title to your car so that if you don’t pay I can sell it for what’s owed”, then we would have a loan “secured” by his automobile. If the security for a loan is real estate, then the loan is typically called a mortgage.
- I’m going to write out the loan terms in a document that is called a “promissory note.” That’s just a personal loan written out and signed by the parties with a promise to repay. You can agree to some collateral in a promissory note, but it usually is unsecured.
- Writing out the loan terms does several helpful things: 1. Memorializing the obligation helps to strengthen the obligation. Signing the document fortifies the seriousness of the commitment. 2. Memories can fade about the terms of the loan as years pass. The writing sets forth the exact terms and conditions from the start for future reference.
- Loans and gifts are closely related, especially within families. Because there are limits on how much you can gift tax-free each year ($19,000 per person in 2025), the IRS is well aware that some folks try to use a “loan” to get around those limits. As a result, the IRS requires you to charge a minimum interest rate on the loan to show it’s legit. The minimum rate is called the Applicable Federal Rate (AFR) and can be found online. Determining the minimum rate depends on the length of the loan and how frequently you will be compounding the interest rate. My son’s loan will be a 10-year loan (he should be on sound financial ground by then), so currently I must charge him 4% interest under the IRS AFR tables.
- Michigan, like most states, limits the amount of interest that can be charged on a loan. Laws limiting interest rates are called usury laws and in Michigan the limit is 25% annually. Unfortunately, there are lots of ways businesses can get around that limit and charge a higher rate, but you should stay within that boundary on any type of personal loan.
Now, despite being a lawyer I don’t have a heart of pure stone (close, but not pure). I may very well forgive the loan over the years and as long as I stay within the applicable gift tax exclusion, then there are no tax consequences. Heck, I even made him link one of my bank accounts to his university because if I pay the tuition directly then the $19,000 gift tax exclusion limit does not apply. I left all of my options open, and I told him I’m expecting first class treatment when I can’t get out of my rocking chair anymore. Things seemed so much easier when the only issue was what type of pizza to get for his soccer party sleep over. I guess I need to remind myself of something I tell clients all the time: Figuring out the best way to help out with tuition for an advanced degree for my son is a “good problem to have.”
Fun Fact: I was watching the Lions game this weekend with one of my sons and I complained about all of the downtime (mostly filled with commercials), so I looked it up: There are about 18 minutes of actual live gameplay during the typical NFL game that airs for over 3 hours from start to finish. I prefer to tape the games and run through all the downtime, and both of my sons remind me that’s proof of my old age (LOL).
