Taking a loan out privately – from a family member, for instance – can be one way to borrow money interest free, or at least at a cheaper rate than from a bank.
Raiding the “bank of Mum and Dad” is becoming ever more common as people in their 20s and 30s seek help to buy their first property or pay off student debt.
But there are still important tax implications to consider when borrowing money from a family member, friend, or through other private loan channels.
How do private loans work?
How flexible the terms of loans between friends or family members are usually depends on how close a relationship the lender and recipient have.
Parents – or grandparents, aunts etc – who give money to children may treat the amount as a loan to begin with, with a view to it becoming a gift once they are confident they will not need the funds themselves.
They could also loan money to a trust written in the child’s name. This would allow the child to benefit from any return on the funds, but would mean the capital remains at the parents’ disposal should they ever need it.
Do private lenders usually charge interest?
There is no obligation for anyone lending money to charge interest, and accountants say it is rare to see someone charge a close family member for borrowing money.
But someone lending money to a more distant individual may come to some agreement over interest and repayments. This can be drawn up as a legal document between the two parties, and the lender can sue the borrower if they do not meet the terms.
If the lender does charge interest then this is taxable. Also, the borrower may qualify for tax relief on the interest, depending what they use the money for. If they invest it in a business, for example, the interest on the loan repayments will qualify for tax relief.
What other tax issues are there when lending to a family member or friend?
The main issue to think about when lending money privately is inheritance tax. A loan still forms part of your estate for inheritance tax purposes. It only falls out of your estate if the debt is waived and becomes a gift. At this point – rather than when the loan was initially made – the money becomes a potentially exempt transfer (Pet), so will not be liable for IHT if you live for at least seven years.
Mike Warbuton, senior tax partner at Grant Thornton, says people often fall into the trap of lending their children money and then forgetting about it. In this case the loan would technically still be in the donor’s estate for IHT purposes. It is therefore worth confirming in writing to the recipient that the money can be treated as a gift.
If a child lends money to their parents then this becomes an allowable debt for offsetting IHT. So, say a child lends their parents £100,000, which they spend on day-to-day living, and the parents also own a £400,000 house. When they die, they can knock off the £100,000 debt from their IHT bill. In this instance this would leave them with £300,000 of assets, which is absorbed by the IHT allowance, so no tax would be due.
Is there anything else to consider?
Parents lending to children might think about putting in place some protection to ensure the funds are kept within the family if the child splits from their partner. You can put a legal charge on the funds – so if your child separates from their partner, the money will go back to you, rather than being split between your child and their partner. In this case, the loan amount would not leave your estate for IHT purposes.
Does anywhere else offer private loans?
There is an organisation called Zopa that has positioned itself as a “social lender”. It is an online platform through which people can lend to and borrow money from each other, sidestepping banks.
The plus side is that the lenders and borrowers can potentially secure better rates, as this process removes some of the overhead costs involved in borrowing from a bank.
But the downside is that, as a lender, there is no guarantee that you will receive your money back. Every borrower is identity-checked, credit-checked and risk-assessed, however, and Zopa has experienced very low levels of bad debt.
A number of other private loan sites have set up in other countries, such as Prosper in the US, Smava in Germany and Boober in the Netherlands.
Are the rates from private sites really that much better?
It depends who you are. Zopa is currently advertising a £5,000 loan over three years for a rate of 6.8 per cent. This beats some of the rates from high street banks: Halifax is offering rates of between 6.9 per cent and 10.9 per cent for loans of £7,000-£10,000, while Nationwide typically charges 7.9 per cent on loans of £7,500 plus.
But according to Moneyfacts.co.uk, the comparison website, there are better rates elsewhere. It says Barclaycard and Moneyback Bank, a division of Alliance & Leicester, for example, are offering the same loan terms at 6.3 per cent.
Zopa says its lenders typically receive a return of 7 per cent – before tax.