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Key Takeaways
- A below-market loan from a relative sounds like free money, but IRS rules set a floor on what family lenders must charge.
- Should a relative who lent you money die before you’ve repaid it, the balance becomes part of her estate.
A recent post on Reddit’s r/Mortgages laid out a dilemma many people would love to have:
Got the call of a lifetime last night. My grandma called me and decided to play bank and loan us what I presume would be our inheritance—up to $500K—at 1% interest to pay off our mortgage and any other debts. We would have to pay it all back in 15 years.
With 30-year mortgage rates hovering above 6%, a 1% family loan could save you more than $370,000 in interest over the life of the average mortgage size of $381,0000. Even if a relative charges the IRS minimum of 4.63% for a long-term loan, you’d still save around $125,000 compared with going to a bank.
The IRS Problem Nobody Mentions
A 1% loan sounds like a gift, and that’s how the IRS would view it.
The tax code doesn’t let family members lend money at whatever rate they want. Each month, the IRS publishes applicable federal rates (AFR)—the minimum interest lenders must charge, even relatives. For January 2026, those rates are 3.63% for short-term loans and 4.63% for long-term loans (anything over nine years).
“A loan is generally ‘below-market’ if its interest rate is less than the Applicable Federal Rate,” said Felipe Janica, a partner at EY-Colombia. “So 1% is far below AFR.”
If a relative charges you 1% on a 15-year loan when the AFR is 3.81%, the IRS treats the difference as a gift from her to you. On a loan for $381,000, that “phantom interest” adds up to about $13,000 per year your relative has to report as taxable income.
That amount also counts against the IRS’s annual gift tax exclusion of $19,000.
Your Loan Doesn’t Die With Your Relative
If your family lender passes away while you still owe them money, that loan doesn’t disappear. It becomes part of their estate.
“The unpaid balance becomes an asset of the estate,” said Keith Feinberg, chief wealth strategist at Five Eleven Partners. “If it’s not collected, the burden shifts to the other people inheriting from the estate, as the entire estate would be down the unpaid amount of the loan.”
If the estate forgives what you owe—or you can’t pay it back—your relatives’ inheritance shrinks by that amount. Even if you can pay, the estate now holds the unpaid loan as an IOU instead of cash, which can complicate how assets are divided and create tension with other heirs who may want their share now.
If you don’t document the loan properly, “the IRS may even decide to treat the loan as a constructive gift and apply this against the grandmother’s estate and gift tax exemptions,” Feinberg said.
When Family Loans Go Wrong
The tax rules are manageable. Family dynamics often aren’t.
“Money sharing in the family almost always complicates relationships, mostly because of the unsaid expectations,” Nathan Astle, a financial therapy consultant at Beyond Finance, told Investopedia. “The biggest problem with borrowing from family members is that the ‘terms and conditions’ don’t tend to be very clear. Lack of clarity most often means disappointment and resentment.”
What if you lose your job and miss a few payments—does the lender expect you to prioritize their loan over your other bills? What if they need the money back early? What if other relatives feel slighted that you got a sweetheart deal and they didn’t? These conversations rarely happen upfront, and by the time they do, relationships are already strained.
“The best financial decision isn’t always the right decision,” Astle said. “If I break a term with a bank, the consequences are financial ones. It doesn’t mean I don’t get invited to Thanksgiving dinner.”
Get It In Writing
Treat it like a real loan because the IRS will.
“If you are going to borrow from family members, it is highly recommended to get the agreement in writing,” Astle says. “The best written contracts leave no room for misunderstanding.”
That means a written promissory note spelling out the loan amount, interest rate (at or above the AFR), repayment schedule, and what happens if either party dies. Keep records of every transaction.
Set up automated payments, keep records, and make sure the lender talks to a tax professional since the IRS rules aren’t intuitive to everyone.
When To Walk Away
Say no if repaying would stretch your budget, if relatives might need that money for their needs, and if family relationships are already tense.
“This situation can be life-changing,” Astle said. “However, you need to be intentional and thoughtful about what relational consequences might show up if something went wrong.”
