When you lend money to people you love, you put those relationships in jeopardy. But it’s hard to say no to someone who’s asking for your help out of a bind.
This is tricky terrain to navigate, financially and personally. Before lending money to anyone you care about, take measures to reduce your financial risk and avoid lasting damage to the relationship.
Tips for Lending Money to Family and Friends
You’re not in the business of lending money, and you wouldn’t offer personal loans to strangers. So when your friends or family members come to you with their palms out, it puts you in an awkward position, pitting your better financial judgment against your relationship with them.
Follow these steps to minimize your risk of both financial and relationship damage.
1. Never Say “Yes” on the Spot
When someone comes to you asking for a loan, don’t say “yes” in the moment.
Instead, respond with a delay tactic: “I’ll review my finances and see if it’s even possible right now. In the meantime, I’ll point you toward some other creditors that might be able to help.”
You can then direct them to personal loan providers such as SoFi, low-APR credit cards, or credit cards for people with bad credit. With any luck, they’ll solve their own problem with another lender.
2. Only Lend What You Can Afford to Lose
Professional gamblers tell you never to bet more than you can afford to lose. The same goes for lending to a friend or family member.
After reviewing your personal finances, you may decide you can’t spare a dime at the moment. You have your own financial challenges and budget categories to cover. There’s nothing wrong with saying “no” to a favor request — you’re under no obligation to act as a bank for your loved ones.
If you decide that a small loan won’t break you, prepare for the very real possibility that you won’t ever see the money again. In your own mind, think of the loan as a gift. Just don’t present that attitude to your borrower, so you don’t tacitly give them permission to default.
Never offer a loan that you aren’t willing to forgive both financially and emotionally should your friend or family member default.
3. Schedule a Loan Pitch Meeting
Even as one part of your mind thinks of the loan as a gift, another should think of it as a business transaction. The latter is what you need to present to the borrower, along with an expectation that they treat it similarly.
If you decide that you’re willing to part with a little money to help a loved one, tell them that you’ll allow them to pitch you the loan request as if you were a bank. Tell them to dress accordingly and bring all supporting documentation, and schedule the meeting at a neutral location, such as a coffee shop.
Meet them as if you were strangers, maintaining a professional demeanor. Ask for the exact details of what they need the money for, along with any documentation around it. For example, if they want seed money to start a business, ask for a detailed business plan. If they want help with a down payment on a house, ask what mortgage loan program they plan on using, because most home mortgage programs don’t allow any part of the down payment to be borrowed.
If you feel comfortable doing so, ask for several months’ bank statements, credit card statements, and possibly even tax returns. You can even require them to fill out a loan application and provide a copy of their credit report.
Why all the charade? Because you’re establishing different rules for your relationship surrounding this loan than your normal personal relationship. You want to make it clear that if they’re going to come to you asking for a loan, they need to behave like a borrower. And hopefully a responsible, trustworthy one at that.
It also creates a scenario where you can turn them down more comfortably if you’re not convinced by their pitch or documentation.
4. Charge Interest
Similarly, keep the loan relationship professional by charging interest.
That could mean only a small, nominal interest rate to keep pace with inflation. Or it could mean charging real interest to minimize your opportunity cost.
Because your money could be invested for a proper return — in the stock market, real estate, or bonds, for example. If the stock market earns an historical average of 10% each year, and you lend your ne’er-do-well nephew money at 3% interest, then you’re effectively losing 7% on that money.
Just because you’re not a bank doesn’t mean you shouldn’t invest your money like one if you’re asked to play the role. Your loved one put you in this position, so they can’t complain when you take it on earnestly.
5. Charge Fees
Lenders don’t just charge interest. They also charge fees.
These come in several forms, including upfront fees (points) and late fees. Whatever form they take, agree on the amounts and terms with the borrower — preferably in writing.
A point is a one-time fee due at the loan closing. Each point is equal to 1% of the loan amount. Consider charging 1-3 points upfront.
You don’t have to charge points, but doing so reinforces the message that your loved one has entered a business relationship with you. Points also discourage the borrower from approaching you in the future with loan requests.
For late fees, set a grace period and a late fee amount. Consider a 5% late charge reasonable, and a grace period ranging from 5-15 days for each payment. Always charge a late fee when lending to friends or family members.
6. Agree on Repayment Terms
As part of the loan agreement, discuss the loan terms. These include the timeline for repayment, the frequency of payments, and how the borrower will repay interest and principal.
Timeline for Repayment
Word to the wise: never leave a loan open-ended.
Agree on a timeline for repayment. That could be as short as a few days, or measured in years, but make sure all parties understand the expectations for repaying the loan.
Frequency of Payments
Beyond a timeline for when your borrower must repay you in full, you also need to set a payment cycle. Most people default to monthly without thinking, but it helps to structure repayment similarly to how your borrower earns money.
If your borrower receives biweekly paychecks, consider asking for biweekly payments rather than defaulting to monthly payments. That way, they pay you just after each payday — before their paycheck finds other outlets. If their employer allows them to split their direct deposit into two accounts, you can even collect your money directly from their paychecks.
Alternatively, demand that your borrower set up automated recurring bank transfers to repay you.
Loan Structure
When you take out an auto loan or mortgage, you repay the lender on an amortization schedule. A portion of each payment goes toward your principal balance, and a portion goes toward interest, but it gets complicated because those proportions change over time. Feel free to use a free amortization calculator online to run these numbers.
You could also structure the loan as interest only. In this scenario, the borrower only makes interest payments on a biweekly or monthly basis, and repays the entire principal at the end.
For example, if you lend them $1,200 at 10% interest, that comes to annual interest of $120, or $10 per month. So they pay you $10 per month in interest, and at the end of the loan term they repay you the principal balance of $1,200.
Or you could come up with your own custom loan structure. Say they borrow $1,200 at 10% interest for one year. You might choose to add the interest on top and then divide the payments by 12 to come up with the monthly payment.
The result is that the borrower receives $1,200 but repays you $1,320 over 12 months. That works out to a monthly payment of $110.
7. Consider Taking Collateral
A friend once came to me asking for a large loan. I reluctantly agreed, but charged high interest, several points, and I took the spare keys to his car as collateral.
Theoretically, he could have hidden the car away somewhere I couldn’t repossess it. But I still felt better having the keys as collateral. After defaulting on the payments, he did eventually pay me back with interest.
High-value jewelry makes for better collateral than cars since you can take full possession and the owner doesn’t need it to commute. But it’s also harder to verify the true value of jewelry.
Not everyone owns a possession of real value like a car or high-end jewelry. But if they do, taking collateral on the loan reaffirms the message that your lender-borrower relationship is different and separate from your personal relationship. You aren’t operating as a charity, and there are consequences if they default.
8. Sign a Note
A promissory note is the legal document that borrowers sign. It’s an acknowledgement of the loan and a pledge to repay it.
Promissory notes include all of the details outlined above:
- The loan terms
- The interest rate
- The repayment schedule
- All fees and when they become due
It also details any collateral taken by the lender and the circumstances under which the lender can keep it to cover their losses.
You can find templates for notes online and customize it as you see fit. To really hammer home the seriousness of the loan, require that your borrower have it notarized.
9. Be Open & Transparent with Other Family Members
Family members get touchy about money. If you lend your responsible daughter money in a bind but turn away your less-than-reliable son when he comes knocking, expect a hissy fit.
But as awkward as that sounds, it’s far better than trying to keep family loans a secret from other family members.
Secrets within a family have a tendency to get out. When they do, they’re a recipe for hurt feelings. Legitimately so — families should operate with transparency.
Don’t try to hide loans within the family. If necessary, call a family meeting to discuss it. And if you share finances with your spouse, always ask their thoughts and approval before lending a cent.
10. Don’t Micromanage the Borrower
Once you’ve agreed and inked the deal, the funds leave your control.
You can and should follow up with the borrower if they miss their payments. But aside from asking about missed payments, avoid henpecking your borrower about their general finances. It only breeds resentment, even if you’re just trying to help.
Separate yourself from the money and focus on repayment, not on how it’s spent.
11. Be Careful with Cosigning
Some family members offer to help loved ones qualify for a loan or credit card by cosigning, rather than lending money themselves. They think they’re protecting themselves and their money.
They’re not.
Not only are you still on the hook for repaying the debt, you also risk your credit score. Worse, you no longer have control over the amount of the debt. Your family member could rack up $10,000 in credit card debt without your permission, whereas you might have lent them only $1,000 as a direct loan.
If someone asks you to open a credit card in your name for their personal use or requests that you cosign for a loan, agree only if you trust them implicitly. You can control cash, and lending it won’t directly affect your credit score. When you cosign for a third-party loan or line of credit, you’re on the hook for the balance.
12. Beware of Tax Implications
For tax year 2021, you can give up to $15,000 to a single person tax-free without having to file a gift tax return. Gifts include forgiven debts, so if you lend more than $15,000 and the borrower defaults, plan on reporting it to the IRS.
Uncle Sam also gets twitchy if you provide interest-free loans.
Lending a few hundred dollars won’t get his attention, but if you lend more than $15,000 without charging interest, the IRS may treat the interest you didn’t charge as a gift. For larger loans, charge at least the minimum interest rates set by the IRS.
13. Know When to Say No to Loved Ones
If you’re not sure you can afford to lend money to family or friends, say no. Don’t put yourself at risk by gutting your own emergency fund, simply because someone else got themselves in a financial bind.
There are some other situations where it’s better to think twice or say no, even if you can afford it.
Never Lend to Relatives With Gambling or Substance Use Issues
Turn away friends or family members with either a substance abuse or gambling problem. It feels harsh, but by turning them down, you stop enabling them. You limit their ability to dig themselves deeper into the hole.
Don’t Lend to Defaulters
This should go without saying, but saying no is difficult. Still, if a friend or family member has borrowed money from you before and failed to pay you back on time and in full, don’t make the same mistake twice.
Remember Your Other Relationships
Always keep your other relationships in mind when you consider lending money to a friend or relative. If lending money to a wayward family member would infuriate the rest of the family, think twice before doing it. Lending money might cost you more than just the defaulted loan amount.
Consider Your Role As a Relative or Friend
If you simply don’t feel comfortable with the lender-borrower relationship, decline your loved one’s loan request. Money can drive apart friendships and family relationships, so trust your instincts and simply decline if you harbor any doubts about the loan.
This is often a difficult decision. Remind yourself that grownups need to keep their own budgets, not run to someone else every time they overspend or underearn. When their loved ones enable this behavior, it’s likely to continue.
Brainstorm Other Ways to Help
If you decide not to make the loan, spend some time exploring other ways to help the person or family in need. For example, you might offer a small cash gift or pick up their grocery bill one week. Or you could give them an open invitation to come by for meals.
Final Word
Is lending money to family and friends the best financial decision you could ever make? Probably not. But financial advice aside, sometimes your relationships trump traditional money sense.
If you absolutely must lend to someone you love, make sure you do it with your head and not your heart. Do the work, prepare for the worst, and aim to keep your new lender-borrower relationship separate from your preexisting personal relationship.
