The Friends and Family Guide to Making Personal Loans

Have you ever had that awkward feeling that comes at a family gathering when you’re sitting across the table from someone who you know is buttering you up to ask for a loan?

I have.  It can be amusing, or uncomfortable, but if it catches you and your spouse unprepared, it can be upsetting as well.  If you have family members in need, or who have asked you for personal loans in the past, it’s a good idea to consider your alternatives before you are confronted with the "opportunity" again.

Extending credit and personal loans between family members is a common practice.  Especially in light of today’s economy, many of us know someone who may be on hard times financially.  Does it make sense for us to step up and extend them a personal loan?

Many advisors recommend against loaning money to friends and family.  Too often, things can go wrong and leave bad blood between you, dampening the relationship more than your refusal to extend the loan ever would have. 

Do not feel compelled to loan money, even to close relatives or other people who really need help.  Find other ways to help them like paying part of their tuition costs or mortgage payment if they’re having trouble with bills, hiring them to work around your house (lawn mowing, babysitting, housecleaning, etc.) if they need to come up with cash quickly, or bringing them food, watching their kids while they look for work, or finding other ways to help them reduce the cost of their normal expenditures.

If you’re planning to sit down with needy friends or relatives at Christmas time, plan your strategy in advance. Before they ask, or before you offer, here are some important things to think about regarding loans to friends and family members.

What to consider before giving a friend or family member a personal loan:

• What is their ability to repay?  This is the first thing to consider when giving anyone a loan.  If they can’t repay, you should probably think of it as giving them a gift.  It’s one thing to loan to someone with a job, great credit, and savings in their retirement account who may just be going through a tough time or needs a loan for something big like a medical bill or a new house purchase.  It’s another thing to loan to a broke college student up to his eyeballs in debt with no job prospects.

  When you look at making this decision, think like a bank.  You are making a business decision with your money.  If you are loaning to someone who can’t repay, you are giving a gift, not a loan.  You might as well call it that and save the inevitable bad feelings that will come from a debtor who can’t pay his creditor.

• Get it in writing.  If you do decide to loan someone money, even if it’s just $20, make sure you write down everything.  You don’t have to create an attorney-prepared promissory note if its cost prohibitive.  Contracts you prepare yourself are legally binding if all parties sign and they don’t have any illegal clauses in them.  (If you are loaning a large sum of money, attorney assistance can be invaluable.)

  Your Promissory note should include:  The lender, the borrower, an interest rate, the date the agreement was created, signatures from both parties, and a due date for the repayment of the loan.  It should also spell out fees and penalties that will accrue if the note is not repaid.  (NOTE: I AM NOT AN ATTORNEY, SO THIS IS NOT LEGAL ADVICE).

  Writing down your agreement will create a forum to iron out the terms of your deal and make sure that no one "mis-remembers" what was agreed to later on down the road.

• Do they have any collateral?

One easy way to increase your probability of being repaid is to get something as collateral.  Cars and boats are easy to lien, just stop by the Department of Licensing to get the paperwork to fill out.  Be careful with these assets, though.  If they already have a loan on them, they are usually worth LESS than what is owed on them, so you won’t have collateral protecting your note. 

You can also keep other things of value as collateral – stamp and coin collections, motorcycles, a lawn mower or truck.  The idea is that if they don’t repay you, you can (as specified in your promissory note) sell the collateral item to recover your costs.

Easier said then done when it comes to family relationships, I know.  But if they want to play the game, they have to play by the rules.

• What will it do to the relationship if they can’t repay the loan?  This is a personal question for your consideration.  In my experience, it is usually less damaging of a relationship to avoid loaning money, than it is to have a loan go into default.  The lender and the borrower both feel agitated in that case, and there can be a lot of feelings under the surface that are not addressed.
• Do they have other alternative sources of credit, such as a bank loan?  Before you jump to the ready with your checkbook, find out if the borrower has other sources of credit besides the BANK OF YOUR WALLET.  Can they draw on their line of credit on their home, get a personal signature loan with the bank?  Use their credit cards? 

  I am one of the last to encourage the irresponsible use of expensive forms of credit, but it’s good to know that the person has OPTIONS besides going to you.  I would not encourage them to go to a Pay Day lending source or take a cash advance on their credit cards, as this is EXTREMELY expensive.

  Another emerging new source of credit is peer-to-peer lending sites like prosper.com and lendingclub.com.  These sites allow ordinary folks all around the country to lend money for interest rates (as an investment) and to borrow money when they need access to cash.

• What will the money be used for?  When I was volunteering for a micro-credit banking agency in Nicaragua one summer in college my research partner Julie gave some money to a woman living in poverty whose children had very little food and clothing, no shoes, and lived in a dirt-floored hut.  I remember Julie’s chagrin when the recipient of her charity turned to her baby and said "now we can go buy a candy bar."  That’s not what Julie had in mind when she handed over the money.

Likewise, it can be frustrating to give someone money, only to see it spent on items you consider to be wasteful or frivolous. 

When you extend someone a personal loan, consider whether you will specify how it is spent.

• Is there a way you can assist them without loaning them money?  At the end of the day, often a lack of money is not the problem – or at least not the root of the problem.  Sometimes people need a loan to fix a problem because of other circumstances in their lives that are out of balance.  For example – they own a house and the mortgage payment is more than they can handle.  They have poor budgeting skills, or they are out of work.

  If you are not comfortable giving someone a personal loan when they ask, try to uncover more about the underlying situation and see if there is a different way you can help.  For example – helping them consider ways to increase income, reduce expenditures, or make a big change for the better in their lives.

It’s never easy to be asked for a personal loan.  Especially if money is tight at your house, too, you may have to think long and hard before you decide whether to extend credit to a friend or a family member.

The good thing is that with these questions in mind, you can re-frame the request into a conversation about how to help the potential borrower, while protecting yourself and keeping the peace on the home front.

In this case, I would say be conservative and never loan money you can’t afford to lose.

Have you ever had to borrow money from friends or family?  How did it work out?

Have you loaned money before?  Did you get paid back?  What tips can you offer other would-be lenders?

I’ve loaned money in a business situation before, with everything in writing and a car as collateral, and I’m still having trouble collecting.  Read my collections story here.

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