As lending requirements stay relatively tight for most consumers, the chance of borrowing outside the banking system from family or friends can be attractive. After all, it’s rare to see a parent or sibling demand a credit check or other lengthy documentation.

On the other hand, it could be one of the most dangerous financial transactions you ever make simply because money can drive a wedge between relatives in even the closest of families.

There are good and bad aspects to private loans. The good news first:

• Terms can be significantly friendlier than a borrower would qualify for in the open market. For example, the rate charged on the loan can be higher than the lender would receive in a deposit account but lower than the borrower would pay a commercial lender.
• They can require little or no collateral.
• It’s a way to keep money in the family.
• It’s a way for a borrower to be able to buy a home, a car or other critical assets even if they have a poor credit rating.
• There’s no loss of tax benefits to the borrower or lender if an agreement in the case of a mortgage loan is structured and reported properly.

Now the bad news:

• Unclear agreements can lead to missed payments or default.
• If the borrower dies suddenly, the lender’s investment may be lost if the agreement isn’t structured correctly. A properly executed promissory note is still an obligation of the estate, and may continue to be paid to an heir or other person or entity based on the terms as agreed.
• Jealous relatives could say they weren’t treated fairly.
• Disagreements between borrower and lender could kill an important relationship.

The best arrangements are formal – written in proper legal language, notarized and recorded in the county where the property resides. A financial advisor such as a CERTIFIED FINANCIAL PLANNER™ professional can talk to both parties about what such loans – particularly large loans for real estate or tuition – can mean for their respective finances. It also makes sense for both parties to visit their respective tax professionals to make sure they know the correct ways to document the loan transaction over time for tax purposes.

A detailed document prepared with the help of an attorney or a certified public accountant can also lay out specific scenarios if either the borrower or the lender has to break or alter their agreement. Such trained experts can talk you through the benefits and pitfalls of a private loan arrangement as it affects your particular situation (either as lender or borrower) and specific laws and requirements in your state you have to follow if both borrower and lender are going to derive tax advantages from the agreement.

You should be aware that the IRS governs these interest rates and provides an annually updated table that you can get at http://www.irs.gov/app/picklist/list/federalRates.html – these rates are Applicable Federal Tax Rates (AFR).  You can also forgive a portion of the loan each year up the annual gift exclusion which is $13,000 this year.

Generally, any private loan transaction should include a promissory note that establishes how the debt will be repaid. That’s true for business loans or loans for most types of property. In the case of a business loan, it makes sense for the potential borrower to get specific advice on how lenders in their business will be treated not only in terms of repayment, but default. These agreements are particularly important for tax purposes as well.

In the case of a loan made for real estate, a mortgage or “deed of trust” statement (depending on the state you live in) or an agreement specific to the type of loan that binds the property as collateral for the promissory note will be necessary. It basically says that if you don’t fulfill all the terms in the agreement the lender has the right to foreclose or repossess the property.

Even if a friend or relative makes an offer of help, it’s proper for the borrower to take the initiative to structure the arrangement in a way that’s responsible and beneficial to both. If a relative is drawing income from the loan, special provisions should be made for prepayment and other contingencies.

The most important thing to remember and plan for? When two people who are close to each other enter into such an arrangement, the most valuable thing really isn’t the money. It’s the relationship.

February 2010 — This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by Martin V. Higgins, CFP, CLU, AEP, a local member of FPA.

This is a story about two Fridays, separated by exactly 21 years.

Specifically, it’s an anecdotal recitation of the economic, financial and market disasters that have relentlessly plagued America and the world between those two Fridays, and of the remarkable – indeed, almost unbelievable – place that these disasters left us, 21 years later to the day.

The first of the two Fridays was October 16th, 1987. It was a pretty significant down day in the American stock market, after two consecutive but not terribly ominous declines on the Wednesday and the Thursday.
Stocks had actually been having a fairly difficult time since late August. Gold and commodity prices were rising with inflation concerns; interest rates had turned noticeably higher for the same reason. Equity valuations were historically very high, rendering the market vulnerable to some sort of correction.

But nothing on that Friday suggested the magnitude of what was to happen the next trading day: Monday, October 19, 1987. From the opening bell, stocks declined catastrophically. Because of a huge imbalance of sell orders, specialists on the floor of the New York Stock Exchange were unable even to begin trading some stocks for an hour and more.

Prices fell relentlessly throughout the day – and then accelerated, in a panic-driven rout, in the last ninety minutes of trading. When the tape stopped running, long after the close, the market was found to have fallen in excess of 23% — the largest one-day decline in history, before or since.

Time magazine’s cover expressed the universal consensus: “THE CRASH: After a wild week on Wall Street, the world is different.”

Not long afterward, in 1990-91, came a cataclysmic collapse in the real estate and banking industries. Any number of major banks were said to be teetering on the brink of insolvency, as the value of the collateral on their portfolios of home mortgages sank below the mortgage balances.

The savings and loan system in our country was liquidated under the auspices of a new federal agency, the Resolution Trust Company. A war loomed in the deserts of Kuwait. The first real recession in almost a decade took hold of the economy. And the stock market spiraled down into bear market territory.
Time’s cover showed silent film star Harold Lloyd hanging from a clock tower, and headlined: “HIGH ANXIETY: Looming recession, government paralysis and the threat of war are giving Americans a case of the jitters.”

Soon enough came the terrible summer of 1998: Russia, which had been the world’s hottest stock market the year before, defaulted on its sovereign debt, rendering its currency worthless. The largest hedge fund that had ever existed, Long-Term Capital Management, vaporized all its equity; it was found to be still holding billions of dollars of positions which, if they had to be settled all at once, would have caused the global trading system to cease to function. And, like malignant dominos, the world’s emerging markets and economies collapsed, in what came to be known as Asian Contagion 2.

All this brought on a bear market of incredible violence and suddenness in the U.S. No one was safe: even Warren Buffett’s shareholdings in his Berkshire Hathaway declined by over six billion dollars in 45 days.
Time’s cover showed an uptrending chart suddenly breaking and falling to the bottom of the frame, plunging people trying to stand upon it into an abyss. The headline: “IS THE BOOM OVER?”

Not very long afterward came the bursting, in early 2000, of the greatest stock market bubble of all time, as the dot.com mania crashed, and seven trillion dollars worth of equity values – four trillion on NASDAQ alone – turned to ashes. The country was once again gripped by recession. Then came the terrorist atrocities of September 11, 2001. And soon after, the horror of Enron, with all the corporate and accounting scandals that surfaced for months in its foul wake.

A howling bear – in fedora, rep tie and wingtip shoes – graced the cover of Time.

Then, in mid-2007 – with the stock market barely above its levels of seven years earlier – the housing market in this country collapsed, uncovering a seemingly bottomless cesspool of defaulting loans and worthless derivatives. These hundreds of billions of dollars in losses cascaded into a credit crisis that ultimately froze the financial system of the entire world, and sent our stock market into (at this writing) its third deepest bear market since the 1929 – 32 event.

Time’s cover featured a stark black-and-white photo of a line of destitute men waiting at a Depression-era soup kitchen.

This brings us up to the second Friday which bookends our litany of disaster: October 17, 2008 – 21 years to the day (if not precisely the date) after our story began – and, not coincidentally, only one day after the  greatest single-day percentage decline in the S&P 500 since October 19, 1987.

And where, after all this destruction and chaos, did equity values stand on the second Friday – five bear markets later — compared to the first?

Dear reader: on a total-return basis (that is, price change plus dividends), the broad equity market stood just about five times higher on October 17, 2008 than it did on October 16, 1987.

Five times higher.

This startling truth may suggest — to the long-term, goal-focused investor – a couple of very important conclusions.

The first is that what really matters isn’t the temporary erasure of equity values which happens during this or that evanescent crisis. It’s the staggering increases in values (and dividends) which take place in the great expansions which resume after – and ultimately overwhelm the effects of – even the most significant setbacks.

And the second is that the most reliable source of the accretion and maintenance of real wealth remains, as it always has been, the ownership of diversified portfolios of the great companies in America and the world.
Gold, and oil, and “new era” technologies, and condos in Palm Beach, and exotic hedge funds, and numberless other financial fads have always strutted and will always strut their hour upon the stage, drawing the hard-earned savings of the greedy and the credulous to destruction.

While the earnings, cash flows, dividends and share prices of mainstream equities march on – through crisis after cataclysm after unimaginable disaster – to fund the most cherished goals of the patient, disciplined long-term equity investor.

Take a good look around. Try not to think too much about where the values of the great companies are
today, late in this fifth major bear market in just 21 years.

Try to imagine – if you can – where they will be 21 years from now.

© 2008 Nick Murray. All rights reserved. Used by permission.