When it comes to lending money to family or friends, you’ve heard the warning: Don’t do it! Nevertheless, many of us will be at one end or the other of these loans at some point.
Even financial planners, who have seen how these loans can go well or go terribly wrong for their clients, have lent money to their loved ones and a couple of them offered to share their rules for making these loans work.
1. Make it official.
You can ask the borrower to sign a promissory note spelling out the terms of the loan. This will serve a couple of purposes. For one, it clarifies that you are making a loan, not a gift. Additionally, if the borrower doesn’t repay the loan, you always have the option of taking them to court to collect. (Whether you’d want to go to those lengths is another matter we’ll discuss in a moment.)
“Create a written agreement with fixed payments at least monthly (i.e., don’t ‘pay whenever you can’),” recommends Cheryl Krueger, a financial planner at Growing Fortunes Financial Partners in Schaumburg, Ill. “Even if the start date is a year down the road, there needs to be some structure,” she says.
And don’t feel badly about charging interest: you should. “To stay on the right side of the IRS you must charge a minimum rate,” says Tom Roberts, a financial planner in Sarasota Florida. Otherwise, the loan could be construed as a gift and may fall under gift tax rules.
One father I know took his daughter to the local courthouse where they recorded a lien against his daughter’s vehicle. If she fails to pay him back the money he lent her to buy her car, he can repossess the vehicle. She’s definitely taking it seriously.
2. Have a plan.
Roberts suggests lenders set up a repayment plan that matches the terms of the loan to the borrower’s circumstances. For example, in a loan to a family member that he was involved with, “we put in a grace period to let her get on her feet and then made the payment schedule match her pay period — 2 weeks — to make it more likely to be paid.” His story had a happy ending, with the loan paid off early.
Don’t forget to consider what you will do if a borrower starts having trouble making payments. Will you consider modifying the terms of the loan? Charging a late fee? And most importantly, will it create a financial hardship for you if they can’t make payments? If so, you’re better off saying no.
3. Look beyond the loan.
Does the borrower eat out more often than you do? Visit a salon for a mani/pedi every week? Scoop up the latest iPhone or hot tech gadget? Those spending decisions may not bother you now, but if you see them spending money frivolously when they owe you money, it may drive you nuts. “If you can’t make the loan without judging the spending choices, don’t make the loan,” warns Krueger.
4. Get everyone on board.
Your spouse or partner should be on board before you hand over any money, suggests Brooke Salvini, a financial planner in Avila Beach, California. Similarly, if the borrower has a spouse or partner, they should understand the terms of the loan and agree as well. The way partners or spouses react to or handle the loan could create long-term hard feelings for everyone involved.
One of my relatives still harbors ill feelings over a loan among family members that went bad many years ago. Even though she wasn’t directly involved, it really upset her that the borrower defaulted, claiming the loan was a gift and not a loan. What made her even more angry, however, was that the wife of the person who took the money took her husband’s side and refused to make it right.
5. Be ready (and willing) to forgive.
Despite your best efforts, there’s always a chance some or all of the loan will go unpaid. After all, your borrower is probably what lenders would call “high risk;” or they wouldn’t be turning to you instead of borrowing through traditional channels. “Decide when to ‘let it go,’ and once you’ve passed that point, tell the borrower that you’ve forgiven the debt. Don’t let the money get between you and the borrower,” says Krueger.
Salvini agrees: “If you can’t embrace the idea that personal loans all too often become gifts then don’t lend the money to begin with, unless you are OK with losing a friendship or carrying anger toward a family member.” She adds that she’s still waiting to be repaid for a “$10,000 loan/business investment (gift) and these rules have kept me sane.”