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
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,
A better tack is to ask some important questions of yourself and
the borrower, lay out a clear written agreement, then follow up
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
Do I 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."
How much 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.
How will my relationship to the borrower be
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
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
Why do 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
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
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 Start-Up
Is there 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
"That way, you honor the friendship and stay engaged,
but you also put up your own need not to do this," she
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 written agreement
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
2012 study in the Journal of Economic
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 been repaid.
"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 per
. 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
. 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 repay.
Also, know that you won't be able to report loan payments to
credit bureaus. They are not set up to accept reports from
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
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 transaction."
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