The Perils of Loaning to or Borrowing Money from Family or Friends

Are you thinking about loaning to or borrowing money from a friend or family member?  Perhaps you’re considering co-signing a loan for someone.  Maybe you should reconsider and make a gift instead.

While sometimes you don’t have much of a choice, loaning to or borrowing money from family or friends is fraught with problems.  The transaction immediately changes the dynamic of the relationship because you are no longer just friends or family members; you are now entwined in a business transaction.  This is a business transaction that probably doesn’t observe many, if any, of the formalities of business loans, lest those formalities taint the relationship.  You’ll make excuses like “She’s my friend” or “He’s family, we don’t need formal documents, I trust him.”  Oh but you do.  You really do.

Sure, while payments are being made on a timely basis and everyone is playing by the rules, everything’s just cool.  But once a payment is late, or not made at all, both parties begin to feel uncomfortable in each other’s presence.  Should you say something, ask about the money, or should you just wait a few more days?  Sure, he was just too busy, and probably forgot.  The lender starts making excuses for the borrower so she doesn’t have to confront him.  Then the borrower loses his job, has a catastrophic loss, or otherwise falls ill.  Days turn into weeks, and weeks into months, and maybe into years, but no payment surfaces.  The lender musters up the courage to mention something about it at one point, and the borrower offers excuses for not paying, and promises to pay soon.  You both feel bad about having to discuss it.  The promised day comes and goes without a word or a payment.  The borrower starts to avoid the lender.  Resentment starts to fester.  A confrontation eventually ensues; it’s not good.  The relationship is forever tainted, both parties are resentful.  The borrower is resentful because he can’t believe that the lender doesn’t trust him long enough to pay her back.  The lender is resentful because she trusted him to keep his word, pay on time, and avoid any confrontations.

The above scenario plays out quite a bit, I’m sure.  People want to believe that their friends and loved ones don’t need written documents to pay back money they owe.  They want to believe that life isn’t messy, that the borrower will be healthy and fully able to pay them back with no hassles and no delays.  But that’s not realistic.  Lives change, people change, they move, they lose jobs, they change relationships, and, when they get into trouble, justify why they should not have to pay the money back.  “He doesn’t need it”, “I did her so many favors”, “I’ve fallen on hard times, so I’m sure that she understands” are a sampling of the justifications people use.  In many cases, they don’t take the time to talk to the lender to try and work it out.  Instead, they avoid the subject, hide, and hope the problem will just go away.

In most cases, it simply makes more sense to just give a gift to the friend or family member and not expect repayment.  Whether we’re talking about $20 or $20,000, you really have to ask yourself what would happen if you loaned the person the money and they did not pay it back.  Depending on the amount, you can probably count on the fact the the relationship is forever tainted, if not over.  So when that friend or family member asks to “borrow” some money, depending on your financial ability and the amount requested, you might just want to give it to them and tell them that you don’t expect repayment.  If they do repay it, then great.  If they don’t, then you weren’t expecting repayment so the above scenario does not play out.  For smaller amounts, this just makes sense.

If you’re the borrower, then also think twice about asking a friend or family member for money.  If a bank or other 3rd party lender won’t loan you the money, there’s a good reason for it: they probably believe that you’re just not going to be able to pay it back, and therefore you’re not worth the risk.  Going to a friend or family member for the money just puts them on the spot, and sends the message that although you weren’t a good enough credit risk for a legitimate lender, that they should trust you to pay them back.  That’s not fair to your friend or family member.

Similarly, if someone, or anyone, asks you to co-sign a loan, don’t do it. Ever.  Odds are very high that you will end up paying off the debt.  Again, the bank is saying that the borrower’s credit is not good enough to get the loan, and therefore they don’t believe that the borrower would be able to pay it back.  So having a qualified borrower co-sign it just means that the co-signer is equally liable for the loan, and the lender can go after her for the full amount when the primary borrower does not pay.  Sometimes the co-signer doesn’t find out that the borrower has defaulted, especially if it’s a long term loan and the co-signer has moved or changed phone numbers and cannot reach the co-signer.  By then, the co-signer’s credit record is tarnished and collection agents are searching for her.

If you must loan friends or family a rather large sum of money, then you have to protect your family and yourself.  Once you are married or have kids, you have a primary responsibility to look out for their best interests and ensure that they can recover the money if something should happen to you.  If the borrower balks at using paperwork, then you already have your answer and have just saved yourself a bit of money and headaches down the road.  So here’s what you need to know to do it right:

  1. Make sure that you draw up the proper loan paperwork.  Get legal help to draft the documents, especially if collateral or real estate is involved.  Any office supply store can provide a simple loan form, or search for one on the web.  For a small fee, go to Virgin Money to set up the whole thing.
  2. Charge a reasonable rate of interest.  This is an IRS requirement for loans between related parties, or they will impute additional taxable interest income to the lender, and the borrower will likely end up with more non-deductible interest expense.  Go to the IRS web site for more information about applicable federal rates and loans between related parties.
  3. Spell out as many of the terms of payment (time, place, form) and remedies for default in the loan documents.
  4. Follow up and communicate on non-payment early and often.  It’s better to stay on top of it and let the borrower know that you still expect payment.  Seek legal advice about collection rights and responsibilities if necessary.

When it comes to loaning and borrowing money between friends or family, learn to just say no if you value the relationship.  Perhaps you can help the would-be borrower by pointing them to other peer-to-peer lending sources such as Virgin Money, Prosper, or Zopa. (1)   If you end up with a deadbeat borrower, then you’ve probably lost a friend or close relationship in addition to your money.  Alas, this is the price of mixing friends and money.

(1) I have not performed any due diligence on the the listed peer-to-peer lending sites and cannot vouch for their services.  TheMoneyGeek does not endorse them nor receives any compensation for mentioning them.

Posted in General. 1 Comment »

One Response to “The Perils of Loaning to or Borrowing Money from Family or Friends”

  1. naysh Says:

    never loan money to friends. Suggest a consumer loan or some pawn shop somewhere

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