Loans Among Friends and Family/ June 8th, 2021
Social lending—transactions between friends, family, and business associates—is an attractive option to borrowers who can’t get a loan from a financial institution. In the best-case scenario, a loan between friends or family members is mutually beneficial. Of course, the best-case scenario isn't something you can count on.
To lend or not to lend?
If you aren't in a financial position to make a loan, then you simply tell the person making the request, “Sorry, I can’t.” If you have the money to spare, there are a number of things to consider before responding to the request:
Why are you being asked for a loan? There might be a good reason someone would ask you instead of a financial institution for a loan. For example, your sister just got divorced and has not yet established credit in her own name. If there isn't a good explanation for not being credit-worthy, then you’ll take a great risk in lending the person money.
What is the likelihood you will be repaid? Has the person mentioned a bad credit score, complained about collection calls, or spent money frivolously? That might help you predict whether you'll get your money back. The National Foundation for Credit Counseling (NFCC) calls lending to friends and family "a gamble," and warns, "Don't risk more than you can afford to lose."
How far are you willing to go to get your money back? Are willing to sue or repossess collateral if the person defaults on the loan?
How would you be affected if you never got your money back? Would your relationship with the borrower would be damaged if he or she didn't repay you?
Be clear about loan terms. Ideally, a loan between friends or family would be a win-win situation: You, as the lender, would earn a competitive interest rate on your money while also helping someone out. The borrower would get credit that might not have been available from a traditional source. However, if you ask people who have lent money to friends or family, you will learn that such arrangements are rarely ideal. Experts acknowledge that money often is the wedge that drives people apart. But you can improve your odds of keeping your relationship intact if you're clear about your expectations. Here are some of the terms and conditions you should agree on before money changes hands:
- Loan amount.
- Interest rate.
- Payment schedule. Are payments to be made monthly? By what date each month? When is the loan to be repaid in full?
- Payment amount. Use an online calculator to calculate the amount of each payment, or the accrued interest at the end of the term if the loan amount will be paid in one lump sum.
- Payment method. By check? Direct deposit?
- Late payment penalties. Will you charge a late payment fee or take a specific action if a payment isn't made on time?
- Security interest. Will the loan be secured by any personal property?
- Recourse for default. Spell out exactly what recourse you would take for nonpayment. Would you file a lawsuit or repossess the car that was used as collateral?
Be very clear about all loan terms and conditions and to put them in writing. Also, keep a record of payment so there is no dispute later.
Making the loan official
Experts encourage lenders and borrowers to put the terms in writing. A promissory note, used to formalize a loan agreement, is a promise to pay someone money. Having the signatures on the note notarized makes your evidence of the debt even stronger. However, the NFCC warns, lenders should not place too much confidence in a piece of paper: "It won't guarantee you will be repaid. It's simply another layer of protection.”
The more complex your arrangement becomes, the more you may benefit from outside assistance. For example, the right attorney can advise you on how to complete and file documents, what kind of recourse you have if the debt goes unpaid, what precautions to take in case you or the borrower dies before the debt is repaid, and more.
Lending money is always a gamble. And when the borrower is a friend or relative, you've got much more to lose than just the loan balance. If saying no isn't an option, enter the transaction with as much clarity as possible. Or perhaps best of all, encourage your would-be borrower to visit the credit union and qualify there for a fairly-priced loan.