The biggest mistake people make when lending money to family or friends is a failure to plan. They fail to consider the likely outcomes if the loan is not repaid as promised.
Not being paid by anyone makes us angry. Not being paid by someone with whom we have a close relationship makes that anger personal. Often these loans are not made in a commercial manner, where the lender would be investigating and relying upon the borrower’s financial assets and history. Instead the loan is made because of the personal relationship. Then, when the loan goes into default, the lender feels not only the financial loss but a personal disappointment. Often, failure to repay signals to the lender a lack of integrity, or even a personal attack by the borrower upon the lender. Feelings of deception might also enter into this.
Before lending money to a family member or close friend, at least consider the following:
- Have an exit strategy. Know how the money will be repaid before it is ever even lent. Be sure to consider at least the following:
- What would happen if the borrower loses his or her employment or source of income?
- What effect would a divorce have upon the borrower?
- What problems would a catastrophic event such as a medical disaster or an auto accident in which the damages exceed policy limits create?
- How will this loan be treated if the borrower should ever have to file bankruptcy?
- The arrangement should be in writing. That writing should clearly identify the amount being lent, the interest rate, and the terms of repayment, including dates and amounts. Avoiding misunderstandings can avoid later problems and protect relationships.
- If you do not charge interest, it may be imputed by the IRS and treated as income even if the lender does not receive it. It is better to use at least the IRS minimum interest rates.
- Consider having some form of collateral. In my experience, the lender will typically not want to have collateral, but having collateral might well ensure that the loan eventually is repaid. It can also put the lender in a better position than the borrower’s other creditors. This, of course, seems insignificant at the time the loan is made, but can be of great value later when the borrower has financial problems. Having a friendly party holding liens upon the debtor’s assets can be a valuable tool, not only for the lender, but for the borrower as well.
- Unless the amount is insignificant, have an attorney prepare the loan documents, or at least review them. Have this done before the money is exchanged or the documents are signed.
- Monitor and enforce the loan agreement. Letting payments be missed can create an even bigger problem later. Stay on top of the loan and deal with any issues immediately, before they get out of hand.
- Do not lend what you cannot afford to lose. If the lender is married, be sure both spouses agree to the loan. I have seen many instances where once spouse lends to a family member without the consent of the other spouse. A later default then leads to even more personal pressures on both borrower and lender. For the lender, those stresses are now both financial and marital.
- Do not make the loan unless you have considered all of the above and are certain it will be repaid. Under any other circumstances, be prepared to lose the monies you are lending and treat them as a gift to your family member or friend.
While your question did not ask about guarantys of debts for family members and friends, I often see these as well. It is probably even less forethought given to co-signing or guarantying an obligation than there is when money is actually parted with. All of the same factors should be considered, with the additional requirement that the loan documents all be reviewed carefully in advance. Just because the loan is being made from a bank or other institution does not mean that the co-signer or guarantor should not still have his or her own agreement with the borrower, including collateral.
I have seen situations where parents lose their homes or farms because they pledged them as collateral for a loan to one or more of their children.
Guarantys may be negotiable. Instead of signing a continuing unlimited guaranty, the relative might be able to negotiate a limit or cap upon the amount that will be owed if the borrower does not pay.
I have seen or dealt with thousands of situations involving loans or guarantys between family members and friends. They can be beneficial, but always have the potential to destroy the relationship. A party should think long and hard before entering into these transactions, and should take all possible steps to ensure that the loan or obligation will be repaid according to its terms.