The most important aspect of borrowing from parents is psychological. Even if the folks say, “Pay us back when you can, dear,” don’t put your obligation to them on the back burner. Make a payback plan that includes simple interest at the usual market rate.
The best time to make your plan is before you borrow. Be honest with each other as to when payments will come due. Then, visit the nearest stationary store and buy “promissory notes.” A pack costs under $5.00, yet this is exactly what you’d use if an expensive lawyer helped you out.
Each note is a legal promise to pay. It contains the amount, the due date, to whom and by whom the money is owed. It never has to be enforced, but it always can be. There are few defenses to a suit on a promissory note. In fact, a court will usually grant what is called “summary judgement,” a judgement on papers with no trial.
Why would you and your loving parents want a document that comes straight out of the Draconian Legal Code? Two reasons.
First it forces all of you to make a plan. You will have to think through your future cash flow. They will have to think through their future needs. You will have to arrive at a compromise and stick to it.
Second, if you get into real trouble with other creditors, Mom and Dad can quickly protect their interests by getting a fast judgment against you. Like any other creditor, they get paid if they get there first. May as well keep what little money you have in the family when things get tough.
It’s never too late to execute these notes. So, even if you’ve had the loan for years, and now feel you can start making payments, use the notes as a catalyst to finally make a plan.
If you own a home or have other collateral, consider giving Mom and Dad a lien. This makes them feel secure. No matter what they tell you, all parents worry about becoming dependent on their children, even if their children are borrowing money from them! Liens also protect the property from other creditors by making your parents “first in time, and therefore first in right” to collect.
But, what if your parent’s really don’t want the money back? This is called a forgiveness of debt. And, believe it or not, under the IRS, such a forgiveness is taxable to you. So you actually pay Uncle Sam if your parents are generous. If they’ve already made a loan to you, start paying them back, even if you have to do it slowly.
There’s nothing to stop parents from giving you the money back as a gift. So long as the gift from them to you is under $13,000 each year, neither of the parties will have to pay a gift tax, nor will you pay an income tax.
If you find that you can’t pay back the money, tell Mom and Dad it’s okay with you if they consider it an advancement on your inheritance. In this way, siblings get a little more in the will. It’s not ghoulish to talk about it. It will alleviate a lot of guilt and anger, and cut the friction between you and your non-borrowing siblings.