Published January 02, 2014
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:
"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."
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:
"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."
"That way, you honor the friendship and stay engaged, but you also put up your own need not to do this," she says.
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:
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."