Should You Lend Money to Family or Friends?
Ask yourself — and your prospective borrower — these questions when considering whether to bail out someone close to you
In these tight times marked by high inflation and a debated recession, many households feel cash-strapped and squeezed by escalating expenses and interest rates. The first line of defense for many of them involves asking family and friends for money to stay afloat.
As a financial planner, I have witnessed many of my fellow first-generation wealth builders and sandwich-generation wealth protectors face the precarious decision of whether or not to lend money to family members and friends.
Money F.O.G. (fear, obligation and guilt) and pulled heartstrings cloud their judgement as they contemplate the lending decision. They toggle from wanting to lend money and get loved ones back on their feet to having difficulty trusting someone already in debt.
Are you willing to let money jeopardize your relationship with the borrower?
Consider This Before Lending Money
If you're considering lending to a family member or friend, here are some questions you should ask yourself before making that leap:
- Are you willing to lose the money? Lending money to anyone is risky, particularly if it's not a bona fide business transaction. To keep expectations of repayment flexible, you may have to consider the funds "as a gift instead of a loan," as I explained on a recent CNBC segment.
- Are you willing to let money jeopardize your relationship with the borrower?
- What is the emotional capacity of the prospective borrower when handling business matters with family or a friend?
- Will you be able to keep your emotions in check and interact peacefully with a delinquent borrower at your next family reunion or holiday?
Shakespeare opined on keeping drama out of the relationship equation by declaring: "Neither a borrower nor a lender be for loan oft loses both itself and friend."
Questions to Ask a Borrower
At the same time, you should be prepared to ask important questions of the prospective borrower. Money conversations are challenging even for the most secure relationships, and your new role as a lender requires you to be comfortable asking pertinent questions such as:
- Why do you need the money? The answer to this question should clearly define the purpose and sets the terms of engagement.
- What is your plan for repaying the loan? This will give you insight into the prospective borrower's intent and strategy.
- Is your credit score 700 or more? If not, what affected your score? Answers to these queries should provide a window into the prospective borrower's circumstances and behavior.
- Why do you think I have the money to lend? The reply will signal what the prospective borrower believes about you and your financial position and sets an aspirational goal for him or her.
If you don't feel comfortable asking the questions or the prospective borrower balks at providing answers, you both may realize that a loan from you is out of the question.
Family loans also carry tax implications.
Always Get It in Writing
If you decide to assume the role of lender after answering the essential questions above, consider codifying your agreement. Establish a legally binding promissory note to include terms such as the total amount borrowed, interest rate, repayment schedule, past-due payment fees and default terms.
Add the loan to your list of assets on your net worth statement and add language in your will or trust to ensure your estate will collect on your investment upon your death. To assist with its legality, determine if your employer offers a legal benefit service or secure online resources such as RocketLawyer, Upwork and Pigeon Loans.
Don't Forget the IRS
Family loans also carry tax implications. The IRS issues guidelines monthly for setting interest rates on family loans, known as the Applicable Federal Rates (AFRs). The AFR rate ensures that personal lenders avoid assessing below-market interest rates to avoid estate and gift taxes.
While you might not consider yourself a high-net-worth individual, it is beneficial to incorporate a reputable framework to guide your lending terms. Also, it's worth noting that interest on loans is taxable income to the lender. Consult your tax advisor on the best course of action for setting interest rates and reporting interest income.
When asked to borrow your money, think long and hard about what's really at stake and the reward received by both parties for the risk taken.