Should you loan money to friends or family members? My advice is, “Don’t do it! When you mix a lender/borrower relationship with a family/friend relationship, it can be the kiss of death!” It is not about the money, it is about the relationship.
I remember vividly the 76 year-old grandfather who wept in my office after co-signing for his grandson’s first car. The grandson had lost his job and defaulted on the loan after only three payments, leaving the grandfather stuck for the entire debt.
“It’s not the money so much,” the grandfather said, “but he won’t look me in the eye now or even answer my calls! Helping him actually ruined our relationship!”
But some loan their family and friends money anyway, arguing that their situation is a “unique” one in which there is little chance that anything could go wrong!
So since some are going to do it anyway, let me offer 15 suggestions to consider before loaning money to family and friends.
1. Ask a lot of questions.
If your friend or family member is offended by your asking questions, take it as a “red flag” to say “no. When it is your money and your risk, you have a right to know these things:
How is the money to be used?
What other options for loans have been pursued?
Why is a conventional loan not being used?
What is the borrower’s ability to repay?
What risk is involved in how your money is to be used?
What security can be used as collateral for larger loans?
2. Loan cash only.
It is extremely unwise to loan out your credit card, add them as a joint user to your card, or co-sign a loan for them. This can adversely affect your personal credit if any default occurs. Remember that each name appearing on a credit transaction, loan, or co-signed note is 100% responsible to repay the entire debt.
3. Do not borrow in order to loan.
If you have to use credit or secure a loan in order to help your friend or family member, you are not in a position to pretend you are a “bank.”
4. Lend only what you can afford to lose.
If your lifestyle will be adversely affected by non-payment of the loan, you are not in a position to be loaning money.
5. Consider charging interest.
You may think this sounds cold, but it “elevates” the transaction to the level of a business deal, just like the “real world” requires. Having to pay interest is a good incentive to pay on time or even pay off the loan early, plus there can be IRS consequences for doing a “no interest” loan.
6. Is the loan large enough to require security (collateral)?
Posting security for the loan shows that the borrower is willing to “have skin in the game.” It is certainly easier to borrow money if you incur no risk by not repaying it. If security is involved, it would be best to have an attorney draw up the contract.
7. Consider the change of attitude you may have toward the borrower.
Will you see this person differently after he owes you money? And how will you think of him if he does not pay you as he agrees?
8. Have a plan of action if the loan defaults.
You are not being pessimistic by doing this; you are being realistic. Are you willing to actually charge late fees or even pursue legal action if the loan is defaulted?
9. Avoid micro-managing his finances afterward?
If you are constantly going to scrutinize the borrower’s financial management after his loan, it is better to just say “No.” Will you constantly be thinking, “If he did not bowl in that league, go on vacation, or buy that fancy car, he could pay me on time!”
10. Possibly require some financial education.
Before you loan the money, have him read a good book on personal finances or enlist in a money-management course like Dave Ramsey’s “Financial Peace University.”
11. Make the loan against his inheritance.
If this person is in your will, maybe it would be best to deduct the unpaid balance from his inheritance if he defaults?
12. Similarly, determine what happens to the loan if you die unexpectedly?
Will the remaining monies be owed to your estate, be forgiven, or be deducted from any inheritance the borrower may receive.
13. Discuss and agree on all the terms.
Agree on the amount to be borrowed, the interest rate, the repayment schedule, if and when late fees will be charged, and whether pre-payment penalties will apply.
14. Get it all down in writing.
Although verbal agreements are legally binding, they open the door to misunderstandings. A signed agreement to terms that are clearly spelled out is the best way to do business.
15. Do not make a hasty decision.
Do not allow yourself to be put in a situation where you must make a quick decision. “I have to have the money by midnight” would solicit an immediate “no” from the wise money manager.
If after thinking about these 15 considerations, you still think loaning your friend or relative money is a good idea, then think about it some more!
Relationships are some of the most valuable treasures we possess – way to valuable to be forfeited by money.