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The following is a post by MPFJ staff writer, Kevin Mercadante, who is professional personal finance blogger, and the owner of his own personal finance blog, OutOfYourRut.com. He has backgrounds in both accounting and the mortgage industry.
Lending money to family and friends is usually done with the best of intentions. But, this is also a potentially difficult area from both a financial standpoint and a personal one. You want to help a friend or family member, but if something goes wrong you could lose more than money.
What are some considerations you should take into account before lending money to family and friends?
Carefully consider the reason for the loan
Since the stakes are high in making this kind of loan, you should give careful consideration the nature of the relationship, as well as to the purpose of the loan. There are necessary loans and luxury loans, and which it is could impact your decision.
A necessary loan is one that you almost have to make. It will be one to cover a critical need, and doing so is basically what family is all about. An example is a loan to a close family member for an emergency – such as to cover a sudden medical expense. You might go ahead with it without much thought.
And then there are luxury loans, and this is where it gets more complicated. If the loan is to an extended family member to cover the down payment on the purchase of a car, that will also involve a car loan, this is a situation you may want to avoid entirely. But if you are loaning money for the purchase of the first car to your own child, that would be one you’d probably make, even though it is not an emergency situation.
Seriously consider the possibility and outcome of non-payment
When you loan money to family and friends, there is always the risk of losing money, but there’s also the possibility of destroying a family relationship. You have to consider this carefully before extending such a loan.
Some people will make the loan because they fear that if they don’t then the relationship will be destroyed anyway. But, that kind of situation is usually forgotten in a short period of time. Loan defaults however, are not.
If the friend or family member does not pay you back, or pay you back fully, you may harbor negative feelings sufficient to destroy the relationship. Alternatively, the friend or family member may come to resent your efforts to collect money from them. They may even believe that as a family member, you should forgive the debt entirely.
Blood may be thicker than water, but it’s not always thick enough to overcome money disputes. If you believe that there is a real potential for this to happen, you might be better off taking the bitter pill up front by saying no, rather than allowing it the blowup later when the family member can’t pay.
If you make the loan, be sure to formalize it it writing
If you do decide to proceed with making the loan, you should formalize it with a written agreement.
This is partially to protect yourself in the event that the situation becomes a legal matter. But, it is mostly to spell out the specific terms and requirements of the loan. That will put the borrowers responsibilities in black and white, that way there will be no dispute as to what was expected.
Since there is already a relationship complicating the business aspect of the loan, there’s also the possibility that it will be viewed as a casual arrangement. Absent a written agreement, the relative may assume exactly that and not feel any specific responsibility to repay or to pay in a timely manner.
Lend with no expectation of repayment
This is actually a biblical directive – lend money, but do so with no expectation of repayment. In effect, this will make the loan into a gift. But, this also means that you probably should not make a loan to any friend or family member who you are not prepared to give a gift to (always remember to consider gift tax laws as well is you decide to go this route!).
The friend or family member can pay the loan back if they’re willing and able, but from your standpoint, you will view it as a gift. If the loan is not repaid, you will not feel slighted and the relationship will be preserved.
Find another way to help without making a loan
If you would prefer not to make a loan, or you have made loans to family and friends in the past and gotten burned, you might see if you can find other ways to help.
For example, you may decide to provide them with money for trade. You can decide to buy something from them that will provide at least some of the cash they need. Alternatively, you could have them do some work for you in exchange for the amount of money that they need. In this case, they’ll have the money that would’ve been a loan, but you will be compensated in exchange. That will be a win for both parties.
You may also advise them either to avoid the purchase, or to buy something that is less expensive that will not require a loan from you. In this way, you might actually be helping them to avoid taking on an obligation that they really cannot afford the first place. It’s a bit risky, but far less so than if you make the loan and face the possibility of default.
How about you all? Have you ever made a loan to a family member or friend? Did you formalize it with a written agreement?
What happened to the relationship as a result of the loan being paid or not paid back?
Share your experiences by commenting below!
***Photo courtesy of http://upload.wikimedia.org/wikipedia/commons/9/99/Making_friends.jpg