Lending and borrowing money from a bank follows certain procedural guidelines that have evolved over centuries. Meanwhile, personal lending—that is, making loans to or taking loans from friends and family—has been going on for just as long, but firm guidelines haven't developed because each situation is unique.
There is, however, a way to make family loans safer and more secure for all parties involved.
- If not handled carefully, lending money to a friend or family member has the potential to strain both your relationship with them as well as your bank account.
- Before granting a friend or family member a personal loan, it's worth first asking questions like what the money would be used for, when you can expect to be repaid, and what their general financial situation is.
- To minimize the chance for any potential misunderstandings when lending money to a loved one, it's worth clearly establishing the terms of the personal loan, such as the interest rate and repayment schedule.
Before Saying Yes to the Loan
Before you give a friend or family member a personal loan, you're entitled to ask some questions:
- What is the money for?: Regardless of whether the loan is large or small, you have a right to know how it will be used. If the reason doesn't sit well with you (i.e., for a vacation, rather than a mortgage payment), kindly point your prospective debtor to the nearest bank.
- How long will it take to pay back?: If the loan is a bridge loan to the next paycheck, you may feel comfortable with a zero-interest, no-terms handshake agreement. If the loan is of significant size or will take more than a month to pay off, get it in writing. Memories of the original agreement usually fade over time, so you will need documentation.
- What is the borrower's current financial situation?: Personal lenders often realize too late when a borrower is unlikely to pay back their loan. This can lead to attempts to renegotiate after the fact, which can foster resentment between the two parties.
Although this is often overlooked, you have a responsibility to yourself and the other party to make sure that the borrower is in a decent financial situation before loaning money to ensure they're able to pay you back after. It can be uncomfortable, but remember that the borrower came to you for money, not the other way around.
This doesn't mean you can't help. Talk to them about their circumstances and when they can start paying you back. Maybe you can offer to help pay for a financial planner rather than provide a loan.
Establish the Terms of the Loan
Verbal contracts rarely end well. Problems crop up even with small, short-term loans. Writing up contracts for even the smallest loans will discourage people from constantly coming to you unless it's truly warranted.
Both parties should work together on the terms before signing. A personal loan calculator could be useful during negotiations, as it can help both parties visualize the terms of the loan and decide upon monthly payments, a term length, and an interest rate that everyone is satisfied with.
The following are some necessary aspects of any solid loan.
The Internal Revenue Service (IRS) can be nasty when it comes to no-interest personal loans, especially large ones. The IRS uses the applicable federal rate (AFR) as a benchmark for the minimum interest that should be charged on any private loan. If you, the lender, fail to charge that interest, the loan could be considered a gift and be eligible for the gift tax. The IRS publishes the AFR every month. As of July 2023, the AFR for a short-term loan is 4.80% annually.
The repayment schedule should outline the amount and date of each payment. It should also state what happens in the case of a missed payment. You may choose not to have any penalties for late payments, but that can result in the loan payments taking the lowest priority in the borrower's monthly budget—and possibly being bumped in favor of less-than-necessary expenses like a night out on the town.
Conditions of the Loan
Clear conditions need to be written up in the case of the death of either the lender or debtor. With family members, this is especially important because of the dispersion of the estate. If one child had previously received a $10,000 loan, and the estate pays $30,000 to each child regardless, then that could turn a wake into a family feud.
You may want to add additional conditions according to the situation. For example, if you're lending to help someone buy a home, you can secure the loan to the property.
After getting the loan in writing, it's worth running it through a legal and/or financial professional. Your lawyer or accountant will probably have some good advice on conditions and may act as a third party for the signing. Small loans, especially those for less than $500, may not be worth the cost of notarizing the contract, but large loans should be part of the legal record.
Why Giving a Personal Loan May Be a Bad Idea
There are strong reasons against making a personal loan to family or friends. The biggest has to do with your own personal finances. Most people aren't typically liquid enough to risk losing that money, and by assuming that all the money loaned will be lost, you'll quickly realize what size loan you can reasonably make. If you're dipping into a retirement account, emergency fund, or other necessary fund to make the loan, it's not a loan you should be making.
Family conflict, tax problems, and complacency are some of the other things to worry about. If your family or friends come to you for loans simply because you lend at a low (or no) rate, then you are hurting your own finances to subsidize theirs.
A loan from a bank or credit union may be more helpful to a friend or family member in the long run, as it would allow them to start building a good credit score. On the flip side of the coin, when interest rates begin eating away at a borrower's income, any habit of living outside of their means may be tempered.
The Difference Between a Loan and a Gift
The reasons against personal loans to friends and family often evaporate when your loved ones are facing dire circumstances, In this case, you have to make a clear distinction between a gift and a loan. A gift has no expectation of repayment, while a loan should be paid back in full, including any interest, and must be documented in writing. Giving a gift is a personal choice, while making a loan ought to be handled in a more careful manner.
Should I Loan Money to a Family Member or a Friend?
You can certainly loan money to a friend or family member, but you should have established repayment guidelines, including interest rates—if any—and a payment schedule, to ensure both parties are on the same page.
What Questions Should I Ask Before Lending Money?
Before lending money to a friend or family member, you have the right to ask questions to better understand their request. You could ask the borrower what the money's for, when they can pay it back, and what their current financial situation is as a start.
How Do You Lend Money to Family and not Regret It?
If you're hesitant to manage a personal loan for a friend or family member all by yourself, there are third-party companies available that can set up the repayment schedule on your behalf and ensure you're paid on time.
The Bottom Line
Lending money to family or friends can be a nightmare if either party fails to approach it seriously. If you don't feel up for going through all of the aforementioned steps but still want to make the loan, there is an alternative.
Third-party companies that can act as intermediaries in personal lending are available. For a fee, they will handle the contracts and set up automatic payment withdrawals. Some even report to credit agencies, and in the process, can help the debtor build up a good score (providing more incentive to avoid a missed payment). This adds a fee burden to the debtor's loan, but it is better than going forward with a poorly thought-out arrangement.
If all goes well, you will be able to close out the loan, having helped a loved one, without harming yourself. In the worst-case scenario, you've only loaned money you were prepared to lose, and if you choose, you have a legal document to back up a claim.