You probably already know that lending money to friends or relatives can be fraught with risk. Your generous offer of a personal loan may lead to resentment, anger and
even cause cherished relationships to end. Yet you're going to do it anyway.
OK, we won't try to talk you out of it. But at least be smart about it. Often, people will fork over cash with minimal
discussion or agreement. That approach may avoid uncomfortable conversations, but
it is a surefire recipe for misunderstandings and frustration, say experts.
A better tack is to ask some important questions of yourself
and the borrower, lay out a clear written agreement, then follow up regularly.
LENDING TO FAMILY, FRIENDS
A 4-STEP GUIDE
If you're lending money to your inner circle, the following steps can help you keep your shirt -- and your relationship.
Not sure where to start? This four-step guide will help you handle requests for money from friends and relatives:
Step 1: Ask
questions of yourself
Don't be rushed into a hasty decision. After being asked to
lend money, it's OK to take a little time to evaluate the request and revisit
it after having time to think. The questions you should ask yourself include:
expect to be repaid? That's the first question that Andrea Chomakos, a tax
and estate-planning attorney with Parker Poe Adams & Bernstein in
Charlotte, N.C., asks clients who are considering lending money to people they
know. The easiest way to avoid a potentially sticky long-term financial
entanglement is to remove your expectation of being paid back. If you don't
think you'll see the money again, either don't lend it or, if you can afford
it, make it a gift.
"I say to people, 'Recognize that
you are becoming a bank,'" Chomakos says. "If you're not willing to go enforce
that to make sure you get repaid, then you may not want to do this."
can I afford? Try not to let someone else's financial problems become yours.
Assess how much you can afford to lend. Understand that your costs might be greater
than the amount you're lending if, for instance, you dip into retirement
savings and have to pay a penalty. And realize there's a risk you'll never see
the money again, even with an ironclad legal agreement. So don't lend out your
kids' college fund.
my relationship to the borrower be affected? Weigh how much you value the
relationship. Consider how it might be affected by turning down the request, or
by accepting it and becoming financially tied to someone for a period of time.
Understand that by lending money, you are more likely to be drawn into
evaluating the borrower's financial decisions.
For instance, Maggie Baker, a
licensed psychologist and author of "Crazy About Money: How Emotions Confuse
Our Money Choices and What to Do About It," says she once discounted a fee for
a client who said he couldn't afford the full price of a session. But the next
time he showed up, she noted that he drove a Lexus and wore an expensive
leather jacket, which made her second-guess her decision to cut him a break on
her fee. The same dynamic applies to personal loans.
Baker says a lot of people simply
lend money without thinking through the potential consequences to their
relationships. "I understand the temptation of that, but I would advise people
to look at the complexities of what they're getting into," she says.
Step 2: Ask
questions of the borrower
The potential borrower is your friend or relative. You are
being asked for money. Although it is uncomfortable, you have a right to ask
hard questions and have an honest discussion. For example, you should ask:
you need the money? Don't just write a check, no questions asked.
Understand whether the borrower's need comes from a one-time event, such as
unexpected medical bills or a car breaking down, or from ongoing financial
problems. If it's the latter, your loan might just be enabling poor financial
management, in which case you're less likely to be repaid.
"Use your personal experience and
history with this individual to make a wise decision," advises Timothy Burke,
founder and CEO of National
Family Mortgage, which manages home-financing arrangements between family
members. "We tend to know if the folks in our lives are on the responsible side
or the irresponsible side. Do they take their responsibilities seriously, or do
they tend to make excuses?"
The same is true if the borrower
wants money to start a business: Make sure he or she has a well-developed
business plan that sounds plausible and has a chance to succeed, says Sean
Castrina, author of "8 Unbreakable Rules for Business Startup Success."
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another way to help? Listen carefully to the borrower's problems and try to
assess if all other options have been exhausted before turning to you.
Can you offer to help organize a yard sale to make some quick cash? Do you have
a connection with a credit counselor or financial adviser who might be able to
give helpful advice? Instead of just saying "no" to a loan, explore other
alternatives first, Baker says.
"That way, you honor the friendship
and stay engaged, but you also put up your own need not to do this," she says.
What is a
reasonable repayment schedule? You need to get very specific with the
borrower about repayment: How often will you receive payments, and how much
will you receive? While the temptation might be to ask for as much money as
soon as possible, figure out a repayment plan that the borrower can reasonably
afford. Experts say it's usually best to schedule monthly payments so the
borrower gets in the habit of repaying. If that's the case, determine an amount
that can fit into the borrower's monthly budget.
Step 3: Craft a
You'll want a written agreement, called a promissory note,
that spells out how and when you are to be repaid. Having such an agreement
doesn't guarantee the borrower will pay you back. However, it helps remove
ambiguities about the financial arrangement and serves as evidence should you
decide to sue to recover money you are owed.
The promissory note solves one of the biggest problems in
these friendly loans: divergent recollections of the terms of the arrangements.
A 2012 study in the Journal of Economic Psychology showed
that borrowers were more likely than lenders to remember the money as a gift,
rather than as a loan. Recollections also differed on whether the loans had
"You should absolutely have a promissory note because that
will be your best evidence about repayment," Chomakos says.
A simple IOU is better than nothing. There are plenty of
forms on the Internet, too: both free and paid (from legal-services sites such
as LegalZoom or RocketLawyer, and sites that focus on personal loans, such as
LendingKarma and LoanBack). Or you can use the free sample promissory note form developed by CreditCards.com in conjunction with a lawyer. For simple arrangements, these
forms will work fine.
The agreement should be clear on the following points:
To avoid tax consequences, you'll want to charge interest on the loan,
especially if the amount loaned is more than $10,000. If you don't, you'll owe
income taxes on what the Internal Revenue Service calls "imputed interest" --
the minimum interest you would have received. The IRS publishes these amounts, known as the "Applicable Federal Rates," every month, and
they are much lower than what you'd receive from a bank. For example, in December 2013, the interest rate for
personal loans of shorter than three years is 0.25 percent
Make sure the terms are clear. You can figure terms, including interest, by using an online loan calculator. Make sure
the borrower can afford the repayment terms.
If it's a big loan -- say, more than $10,000 -- you might want to ask for
collateral such as the borrower's vehicle. If he or she doesn't pay, you get
the car. This is legally more complicated, and you should discuss any such
agreement with a lawyer.
If the borrower is married, ask that the spouse also be listed as a borrower.
That way, you'd be able to recover the couple's joint assets if they don't
Also, know that you won't be able to report loan payments to
credit bureaus. They are not set up to accept reports from individuals.
Step 4: Follow up
If you have followed the previous steps -- asking the right
questions and devising a loan agreement that works for both of you -- the
borrower should know you're serious about being repaid.
Rather than hounding the borrower every month, you might
suggest he or she set up a recurring payment from a bank account. Or if you
want someone else to deal with the billing and payment reminders, online
services such as LoanBack and LendingKarma specialize in personal loans and
offer the ability to send email reminders and monitor loan payments.
If the borrower starts missing payments, that's when your
tough decisions start. Think of how a bank would handle it: Reach out to the
person and see what the problem is. Maybe you can find a new arrangement that
satisfies you both. But if the borrower is consistently missing payments, you
might have to go to small claims court or hire a lawyer.
That sounds like a drastic step, and maybe one you choose
not to take because you value the relationship. But you will have prepared for
it by being professional and having made the borrower aware of the risks.
Says Burke: "The attitude you really need to take is if you
truly value the relationship, you need to treat the arrangement like a business
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