Lending to Friends and Family: Your 4-Step Guide

You probably already know that lending money to friends or relatives can be fraught with risk. Your generous offer of a personal loan may lead to resentment, anger and even cause cherished relationships to end. Yet you're going to do it anyway.

OK, we won't try to talk you out of it. But at least be smart about it. Often, people will fork over cash with minimal discussion or agreement. That approach may avoid uncomfortable conversations, but it is a surefire recipe for misunderstandings and frustration, say experts.

A better tack is to ask some important questions of yourself and the borrower, lay out a clear written agreement, then follow up regularly.

Not sure where to start? This four-step guide will help you handle requests for money from friends and relatives:

Step 1: Ask questions of yourself Don't be rushed into a hasty decision. After being asked to lend money, it's OK to take a little time to evaluate the request and revisit it after having time to think. The questions you should ask yourself include:

Do I expect to be repaid? That's the first question that Andrea Chomakos, a tax and estate-planning attorney with Parker Poe Adams & Bernstein in Charlotte, N.C., asks clients who are considering lending money to people they know. The easiest way to avoid a potentially sticky long-term financial entanglement is to remove your expectation of being paid back. If you don't think you'll see the money again, either don't lend it or, if you can afford it, make it a gift.

"I say to people, 'Recognize that you are becoming a bank,'" Chomakos says. "If you're not willing to go enforce that to make sure you get repaid, then you may not want to do this."

How much can I afford? Try not to let someone else's financial problems become yours. Assess how much you can afford to lend. Understand that your costs might be greater than the amount you're lending if, for instance, you dip into retirement savings and have to pay a penalty. And realize there's a risk you'll never see the money again, even with an ironclad legal agreement. So don't lend out your kids' college fund.

How will my relationship to the borrower be affected? Weigh how much you value the relationship. Consider how it might be affected by turning down the request, or by accepting it and becoming financially tied to someone for a period of time. Understand that by lending money, you are more likely to be drawn into evaluating the borrower's financial decisions.

For instance, Maggie Baker, a licensed psychologist and author of "Crazy About Money: How Emotions Confuse Our Money Choices and What to Do About It," says she once discounted a fee for a client who said he couldn't afford the full price of a session. But the next time he showed up, she noted that he drove a Lexus and wore an expensive leather jacket, which made her second-guess her decision to cut him a break on her fee. The same dynamic applies to personal loans.

Baker says a lot of people simply lend money without thinking through the potential consequences to their relationships. "I understand the temptation of that, but I would advise people to look at the complexities of what they're getting into," she says.

Step 2: Ask questions of the borrower The potential borrower is your friend or relative. You are being asked for money. Although it is uncomfortable, you have a right to ask hard questions and have an honest discussion. For example, you should ask:

Why do you need the money? Don't just write a check, no questions asked. Understand whether the borrower's need comes from a one-time event, such as unexpected medical bills or a car breaking down, or from ongoing financial problems. If it's the latter, your loan might just be enabling poor financial management, in which case you're less likely to be repaid.

"Use your personal experience and history with this individual to make a wise decision," advises Timothy Burke, founder and CEO of National Family Mortgage, which manages home-financing arrangements between family members. "We tend to know if the folks in our lives are on the responsible side or the irresponsible side. Do they take their responsibilities seriously, or do they tend to make excuses?"

The same is true if the borrower wants money to start a business: Make sure he or she has a well-developed business plan that sounds plausible and has a chance to succeed, says Sean Castrina, author of "8 Unbreakable Rules for Business Start-Up Success."

Is there another way to help? Listen carefully to the borrower's problems and try to assess if all other options have been exhausted before turning to you. Can you offer to help organize a yard sale to make some quick cash? Do you have a connection with a credit counselor or financial adviser who might be able to give helpful advice? Instead of just saying "no" to a loan, explore other alternatives first, Baker says.

"That way, you honor the friendship and stay engaged, but you also put up your own need not to do this," she says.

What is a reasonable repayment schedule? You need to get very specific with the borrower about repayment: How often will you receive payments, and how much will you receive? While the temptation might be to ask for as much money as soon as possible, figure out a repayment plan that the borrower can reasonably afford. Experts say it's usually best to schedule monthly payments so the borrower gets in the habit of repaying. If that's the case, determine an amount that can fit into the borrower's monthly budget.

Step 3: Craft a written agreement You'll want a written agreement, called a promissory note, that spells out how and when you are to be repaid. Having such an agreement doesn't guarantee the borrower will pay you back. However, it helps remove ambiguities about the financial arrangement and serves as evidence should you decide to sue to recover money you are owed.

The promissory note solves one of the biggest problems in these friendly loans: divergent recollections of the terms of the arrangements. A 2012 study in the Journal of Economic Psychology showed that borrowers were more likely than lenders to remember the money as a gift, rather than as a loan. Recollections also differed on whether the loans had been repaid.

"You should absolutely have a promissory note because that will be your best evidence about repayment," Chomakos says.

A simple IOU is better than nothing. There are plenty of forms on the Internet, too: both free and paid (from legal-services sites such as LegalZoom or RocketLawyer, and sites that focus on personal loans, such as LendingKarma and LoanBack). Or you can use the free sample promissory note form developed by CreditCards.com in conjunction with a lawyer. For simple arrangements, these forms will work fine.

The agreement should be clear on the following points:

Interest. To avoid tax consequences, you'll want to charge interest on the loan, especially if the amount loaned is more than $10,000. If you don't, you'll owe income taxes on what the Internal Revenue Service calls "imputed interest" -- the minimum interest you would have received. The IRS publishes these amounts, known as the "Applicable Federal Rates," every month, and they are much lower than what you'd receive from a bank. For example, in December 2013, the interest rate for personal loans of shorter than three years is 0.25 percent per year.

Repayment. Make sure the terms are clear. You can figure terms, including interest, by using an online loan calculator. Make sure the borrower can afford the repayment terms.

Collateral. If it's a big loan -- say, more than $10,000 -- you might want to ask for collateral such as the borrower's vehicle. If he or she doesn't pay, you get the car. This is legally more complicated, and you should discuss any such agreement with a lawyer.

Borrower. If the borrower is married, ask that the spouse also be listed as a borrower. That way, you'd be able to recover the couple's joint assets if they don't repay.

Also, know that you won't be able to report loan payments to credit bureaus. They are not set up to accept reports from individuals.

Step 4: Follow up If you have followed the previous steps -- asking the right questions and devising a loan agreement that works for both of you -- the borrower should know you're serious about being repaid.

Rather than hounding the borrower every month, you might suggest he or she set up a recurring payment from a bank account. Or if you want someone else to deal with the billing and payment reminders, online services such as LoanBack and LendingKarma specialize in personal loans and offer the ability to send email reminders and monitor loan payments.

If the borrower starts missing payments, that's when your tough decisions start. Think of how a bank would handle it: Reach out to the person and see what the problem is. Maybe you can find a new arrangement that satisfies you both. But if the borrower is consistently missing payments, you might have to go to small claims court or hire a lawyer.

That sounds like a drastic step, and maybe one you choose not to take because you value the relationship. But you will have prepared for it by being professional and having made the borrower aware of the risks.

Says Burke: "The attitude you really need to take is if you truly value the relationship, you need to treat the arrangement like a business transaction."