Lending Money to Family and Friends

Lending money to family and friends

Lending money to loved ones could be a gesture of good will -- or it could be disastrous to your own personal finances, depending on the circumstances.

*Ann's co-worker was in a jam. She had car trouble, no extra money and wanted to borrow $500. "Money was tight for me, but I knew it was tighter for her," Ann recalls. So she lent her co-worker the $500. Her friend paid her back, in full, about a year later.

But not all loans work out as well. Beth and her husband lent her stepdaughter, Jan, now 36, about $100,000 -- toward credit card debt, grocery money, school supplies for her kids, college tuition, cigarettes, security deposits and more. They never saw their money again.

Just as borrowers need to proceed carefully, so do lenders.

"It is very hard to pull apart your personal feelings from that business transaction when you loan money to friends and family," says personal finance expert and author Manisha Thakor, CFA. "The biggest downside is ruining the relationship when you don't get paid back at all, which frequently happens."

Learn how you can increase the odds of getting your money back while keeping the relationship on track.

*Alternative names were used in this story to protect sources’ privacy.

Consider the money a gift and repayment a bonus

Ann lent her co-worker with car trouble the money and afterward never mentioned it. "Emotionally, I was always prepared to write that $500 off as a gift," Ann says now. "I was ready to give it to her."

That's exactly what Certified Financial Planner Robert Schmansky recommends.

"If you're going to make a loan to a family member, assume that money is gone from the start," says Schmansky of Clear Financial Advisors in Troy, Mich. "Have the mindset (that) this is money you may not get back. You're on the hook for whatever it is. Don't let the financial consequences of this person defaulting or not making payments interfere with your relationship. Giving a gift is a lot better, a lot cleaner."

You may decide that giving a gift with love is better than a loan. "With family, my personal rule is, 'Only give if you are willing to not ever get the money back,'" Thakor says. "Commit to yourself that you are aware you might not get the money back. But that is a risk you are willing to take because love is more important than money."

Treat the loan as a business transaction

If you can't consider the loan a gift, be just as businesslike as your bank would be.

Lisa lent her daughter, a college student, $700 to buy a computer. Each month, her daughter paid her $50 and watched as Lisa entered the payment in a ledger and updated the amount owed until the money was paid back in full.

To make sure you get paid, Schmansky and Thakor recommend getting everything in writing.

"Set up expectations," Schmansky says. "That way, the family member isn't coming back to you in a year saying, 'Unfortunately, I can't pay you back.'"

You can even set payment up as an automatic debit, Thakor says. Consider getting collateral and charging interest, she recommends.

"When you make a loan, you're assuming risk," Thakor says. "Interest is the mechanism to help compensate for that risk." You can charge a higher interest than you'd get from many savings accounts and still be charging less than the interest on a credit card or bank loan, she says.

Don't take the middle ground

Don't compromise between a gift and a business transaction, Thakor says. "If you do anything in between those two, that's when you're going to get into trouble. All the horror stories you hear about people lending money to friends and family boil down to, 'It's kind of a gift or sort of a business transaction,'" she says.

Beth's loans to Jan were smack in between the two. After one particular bailout, Beth and her husband created a written agreement that specified Jan would meet with them weekly to talk about budgeting. "She showed up once, then never again," Beth says. But Beth and her husband did not insist she adhere to that or other terms, either.

So both sides of the transaction were at fault.

Make your own personal finances a priority

The first moment of truth came about three years ago, when Beth and her husband began tracking spending. "We realized we had bailed her out that year to the tune of about $12,000," Beth says. "I'd like to say the gravy train stopped then, but it actually continued until about a month ago."

That's when Beth and her husband had to pay for a new roof on their own home and realized they needed their cash cushions for themselves. "No wonder my retirement account looks so crappy," Beth says.

Beth had a frank talk with Jan and told her to figure out what was wrong with her finances and to get another job if that's what it took to stay afloat.

Jan figured out her monthly expenses were $200 more than her monthly income. She began applying for second jobs. But she still hadn't completely received the message, since she came to Beth saying she had forgotten her car registration was due.

"I said, 'I'm sorry about that, and what are you going to do?'" Beth recalls. Then Jan asked her dad for a pack of cigarettes, and Beth and her husband told her that not only had routine financial assistance come to an end, but so had gifts of cigarettes and groceries.

Say 'no' to habitual borrowers

Tensions rise when expectations aren't met. When you're waiting for a loan payment that isn't coming, for example, it burns to see your loan recipient spending money on things you consider wasteful. What you consider a want, such as organic groceries or cigarettes, your loan recipient may classify as a need, Thakor says.

Needing money to cover an emergency is one thing, Beth says. Borrowing money for everyday expenses signals a problem. "People who borrow habitually are people who have difficulty saying "no" to themselves and separating wants from needs," she says. "You should not feel guilty saying 'no' to these people."

If you're not comfortable making the loan, don't do it, Schmansky advises. "I can't overemphasize the idea that this person is coming to you because they can't get money anywhere else," he says. "I tell my clients to use me as the bad guy and tell them, 'My financial adviser says this is something that doesn't work with our goals.'"

But when circumstances are right, you may want to say "yes."

Thakor says the upside of lending money is the good feeling you get by being able to help someone else. "Some people will argue it's good karma," she says.

Plus, you may need such a loan yourself one day.