There's a maxim associated with risky investments (think penny stocks) that goes like this: Don't invest money you can't afford to lose. The same holds true with lending money to friends and family, but with an added caution. A "friendly" loan can be a good way to lose money—and tarnish a good relationship with the borrower.
It's hard to turn down requests
for help from family and friends,
but you have to consider your
own financial circumstances, too.
A 2017 study by Lending Tree, a for-profit lending business, bore this out. Almost a third (28.7 percent) of those who borrowed money from, or loaned money to, a family member reported suffering negative consequences. Side effects included discomfort at holiday gatherings, verbal arguments and, in some instances, irreparable harm to a relationship.
FinTech services such as Zelle and Venmo make it easier than ever to send money to friends and family—and the reality is that many of us do find ourselves cash strapped from time to time.
Gerri Walsh, the president of the FINRA Investor Education Foundation, cites data from FINRA's National Financial Capability Study, "Nearly one in five study respondents said they spend more money than their income, and 19 percent have overdrawn on their checking account. When I hear data like that, I also hear the sound of those in a financial tight spot knocking at the doors of relatives or friends to ask for a loan."
"That's not necessarily a bad thing," Walsh said. "But you need to know going into it that you may not get your money back. And if something goes wrong, you can damage important relationships, especially if emotions cloud your judgment when deciding to lend."
Lend This Way
If you're considering lending money to a friend or a relative, here are three tips to make friend-and-family lending succeed.
Lend only what you can easily spare. It's hard to turn down requests for help from family and friends, but you have to consider your own financial circumstances, too.
"You can say 'yes' and feel good about that choice, or say 'no' and feel good about that choice too," Walsh said. "The choice is personal to you. If you can't afford to lose the money, it might be better for all parties involved if you say no."
If the loan is going to make you or others in your family suffer financially—even a little bit—that could cause tensions to flare. You want to remove emotions from the equation as much as possible.
One solution is to lend a little. You might not be able to come up with $1000 without feeling the pinch, but $200 could be painless. Start there.
Loan like a bank. Bob Hope said, "A bank is a place that will lend you money if you can prove that you don't need it." That's another way of saying banks don't lend unless they have sound reason to believe they will be paid back.
Follow the bank's lead. Be realistic in your assessment of the friend or family member's track record of paying money back, and whether you have reason to believe their financial position will improve enough to pay you back what you lent them. Have they borrowed money from you or others before? If so, did they pay back it back?
Do they have the means to pay you back? If the person you are lending money to isn't working or has others reasons that make repayment unlikely, and loan from you is probably not the way to show your support.
You can also act like a bank by documenting the loan—its amount and when repayment is expected. This helps formalize the transaction and keeps both parties from forgetting about the transaction.
Whether you charge interest is up to you. Doing so to a loved one may seem a bit cold, but there are situations in which it could make good sense. For instance, if the borrower is repaying the loan in installments and you worry that he or she could stop paying after a while, the interest payments the borrower has paid early on can help compensate for delinquent payments later.
But the most important reason to charge a certain level of interest, at least in the case of fairly large loans, is to avoid the IRS' gift tax.
In the end, remember you're not really a bank, so if your lender defaults on the loan, chances are you're not going to seize collateral in lieu of repayment.
Lend money with eyes (and heart) open. Know that defaults occur and your friend or relative might not pay you back. Can you accept that?
Defaults happen in the both the professional lending world and in personal lending. Sub-prime auto loan default rates currently are the highest in over twenty years, at 5.8 percent. And payback is even less dependable in the world of friends and family. The Lending Tree study found that the Generation Xers, who borrowed the most money from their relatives (over $23,000 on average), were the most diligent about paying back their loans, with payback rates at 75 percent of the loan amount. Millennials borrowed less, but their payback rate was lower, at only 55 percent of the loan amount.
Still, that's a lot of money that never made it back to the friendly lender.
"Ask yourself: Am I going to resent that person if they don't pay me back? Or am I going to be able to forgive that loan and forgive that person?" Walsh said.
Lend if it's the latter. Refrain if your emotions will get the better of your relationship with the borrower. Sometimes you simply aren't the right person to make the loan.