Encore: Loans Among Friends and Family: Win-Win, or Sure Loss?/ June 27th, 2011
When Shakespeare penned the words for Polonius, in the play Hamlet, "Neither a borrower nor a lender be," he probably was speaking from experience. "Social lending"—transactions between friends, family, and business associates—has long been an attractive option to borrowers who couldn't get a loan as easily or as cheaply from a financial institution. According to various estimates, in 2007 there were between seven million and 10 million person-to-person loans in the U.S. When banks tighten their lending standards, as they've done recently, the odds increase that someone you know will ask to borrow money. 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, the only decision you need to make is how to break the news to the hopeful borrower. If you're flush, 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, you might want to join the other lenders in saying no.
"[The] whole experience taught us a good lesson about loaning money to our children," says Vicki, an Idaho credit union member who co-signed an auto loan for her son and, ultimately, had to let the car be repossessed. "If the banks or credit unions won't lend them money, maybe we shouldn't either!" Vicki was one of several Home & Family Finance Resource Center's What's Your Story respondents.
Remember—if the pros turn down your borrower, there likely is a very good reason.
- What is the likelihood you will be repaid? When weighing your risk, it helps to know something about the borrower's money management style. If you can recall instances when he or she mentioned a bad credit score, complained about collection calls, or spent money frivolously, you might have all the information you need to predict whether or not you'll get your money back. The National Foundation for Credit Counseling (NFCC), a national membership organization of nonprofit credit counseling agencies, 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? Traditional lenders reduce their default rates by employing collection methods that get results. Unless you, too, are willing to sue, foreclose, repossess, or report delinquencies to the credit bureaus, it will be easier for your borrower to default on a loan from you than one from a financial institution.
- How would you be affected if you never got your money back? "Don't ever loan money unless you can afford not to get it back, because you may not," advises Cathy, a credit union member from Alabama. "And don't ever loan money unless you can deal with the fact that you may not get it back, in your heart and mind."
In 2007 there were anywhere between seven million and 10 million person-to-person loans in the U.S.That's a key point: Even if you can spare the money, say no to the loan if your relationship with the borrower would be damaged if he or she didn't repay you.
Be clear about loan termsIdeally, 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. And, depending on the deal you strike, he or she might even save money on interest and fees. If you do an informal survey of people who have lent money to friends or family, however, you will learn that such arrangements are rarely ideal. Gary, a Utah credit union member, says he has "lent money a number of times and, through experience, [has] found there isn't any advantage to lending anyone money." Experts acknowledge that money often is the wedge that drives people apart. But, they say, you can greatly improve your odds of coming out of the transaction with 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. See the next section for information about setting an interest rate.
When banks tighten their lending standards, the odds increase that someone you know will ask to borrow money.
- 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? If so, to what account?
- 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. Would you take legal measures, such as filing a lawsuit? Or repossessing the car that was used as collateral? Or would you simply never lend the borrower money in the future? Spell out exactly what recourse you would take for nonpayment.
Determining loan costYou might think the interest rate you charge for the use of your money is entirely up to you. In fact, the Internal Revenue Service (IRS) has some say on the matter. For 2008, each taxpayer is allowed to give a gift of up to $12,000 to any person without having to pay gift tax. If you're lending more than that, you can avoid the gift tax only by charging an interest rate that is at least as much as the Applicable Federal Rate (AFR), determined monthly by the IRS. You can find the current AFR on the IRS Web site.
Spell out exactly what recourse you would take for nonpayment.To make the loan mutually beneficial, consider charging an interest rate better than what you could earn on your money elsewhere, yet still lower than your borrower would have to pay a traditional lender. You're required to report the interest you receive as income on Schedule B. But uncharged interest, up to the gift-tax exclusion for that calendar year, can be treated as a tax-free gift.
Making the loan officialExperts on the subject strongly encourage lenders and borrowers to make the loan official and put the terms in writing. A promissory note, used to formalize a loan agreement, is a promise to pay someone money. This document, which you can create or purchase as a form, outlines the debt and the terms of the loan. Having the signatures on the promissory 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." Louise, a credit union member from Nevada, learned that lesson the hard way. Despite having a friend sign a promissory note for two separate $5,000 loans, the friend did not repay the money.
Make the loan official."My philosophy is to not lend money now, if I can help it," says Louise. You can download ready-to-fill-in promissory notes, including one for installment payments with interest and one for a lump-sum payment with interest, for less than $10 each from Nolo, which offers legal information and tools for consumers and small businesses. You also can find free samples by doing an online search for keywords like "free sample promissory note." If you think you need collateral on the loan—something of value that you have the right to take if the borrower does not repay the loan as promised—you will need to complete a security agreement along with the promissory note. You can buy a security agreement form online at Nolo.com. You also may be able to find a free sample online. If you're lending money for the borrower to buy a home, it's wise to enter into and record either a mortgage or a deed of trust, depending on where the property is located. This gives you the right to foreclose the property if the borrower defaults. (Recording a document means submitting it to the county recorder's office to be copied, stamped with the date and time, and made a part of public record.) 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 into the transaction with as much clarity as possible. Or perhaps best of all, encourage your would-be borrower to instead visit the credit union and qualify there for a fairly priced loan. Remember—if the pros turn down your borrower, there likely is a very good reason.