When someone is in need of a cash infusion, asking a family member or friend can be one of the first courses of action simply because it is “easier” than seeking out and applying for traditional financing. The scenarios in which a family member or friend asks for a loan are endless and can run the gamut from legitimate need to someone attempting to take advantage of you.
The decision on whether or not to lend money to family or friends is extremely tricky. There is not going to be a one-size-fits-all answer.
Considerations for Giving a Loan to Family or Friends
- Nature and Strength of Relationship – The person you are contemplating giving a loan to might make a huge difference. Lending to a niece to whom you have a close relationship might be less risky than sending money to your third cousin twice removed and five times added. Be careful though – if the situation goes awry and your niece cannot or will not pay back the loan then a meaningful relationship could be forever damaged (whereas you might not care as much about the distant relative).
- Character Assessment – How well do you know the person? Can you attest to his or her character? Are they trustworthy or are there instances from the past that raise concern? Can other family members or friends serve as character witnesses?
- Use of the Money – An important factor to consider is what your friend or family member plans to do with the lent money. Lending to someone who is hardworking and responsible yet just down on their luck makes more sense than to someone who “needs” the money because they overextended themselves traveling the world or being irresponsible in some other fashion.
- Ability to Payback – Perhaps the most crucial element to evaluate is the person’s creditworthiness. In other words, does the borrower have the cash flow to pay you back? This is one of the prime objectives underwriters take when making a decision on whether or not to approve a loan. You won’t necessarily get access to the same information such as tax returns, W2’s, bank statements, etc. (although you can ask for them!). However, it would behoove you to do some sort of assessment on the friend or family member’s ability to pay the loan back.
- Terms – How will you be lending the money? Will it be through a casual understanding or a formalized agreement (it’s much safer for you to require a formalized agreement). Are you going to include a loan term (length until maturity)? How about charging interest? How will the repayment be structured (monthly payments, one lump sum, etc.). Are there any other loan conditions that need to be included? You should clearly think through all of these aspects.
What Could Happen if You Decline to Lend Money to Family or Friends
- Family or Friend Could Fail – Depending on the need for the loan, your family member or friend could fall on hard times. If they cannot obtain money from some other source then they could conceivably fall into a further financial hole. Even finding an alternative source of money, such as maxing credit cards or taking out a personal loan (both forms of bad debt), can cause their overall financial situation to deteriorate in the long run.
- Damage/Ruin Relationships – Hopefully the friend or family member will understand the reasons why you chose not to lend them money and not harbor any resentment. Human nature may very well dicate a different response: bitterness. Resentment may cloud the relationship going forward.
What Could Happen if You Proceed with Lending Money to Family or Friends
- Everything “A Ok” – In a perfect world, everything would turn out as planned. The loan goes to help a friend or family member in need, they repay the loan satisfactorily, and the relationship is strengthened in the process. It could happen…maybe…cross your fingers.
- Lose Your Money – Loan default is a real possibility. Meaning, kiss your money goodbye. Good luck trying to get it back – you might end up on Judge Judy!
- Damage/Ruin Relationships – Damaging or ruining relationships is the most risky aspect of lending to loved ones aside from possibly losing your money. As mentioned above in the example with a close niece, the potential to irreparably hurt relationships exists no matter if you agree to lend or not. It is a Catch 22 – damned if you don’t and damned if you do.
If you loan the money and they do not pay it back it can lead to arguing, legal pursuits or remedies, and can have a ripple through effect to other family and friends as they take sides. It may take years to mend the relationship or it may never be fixable. Are you prepared to take that risk? Is the friend or family member?
When it Might be Ok to Lend to Family or Friends
- Money to Lose – If you are among the minority of people who have piles of extra cash sitting around and you are ok with the money being gone forever, then lending money to friends or family might be an easy decision to make. Even if you have no expectations to get your money back and you do indeed lose it, trust issues could manifest between parties. Make sure you will not hold a grudge.
- Business Loans – If the loan request is for business purposes rather than for personal use then we are talking a whole different ballgame. If the business is legitimate then providing a loan can be the equivalent of making an investment. Due diligence is still urged and doing your own version of underwriting is advisable. Putting all the terms in an actual contract or a promissory note is also highly recommended. It might be wise to obtain a lawyer to review all the paperwork if the sum of money is material. Oh, and if you aren’t in any hurry to get your money back, you might want to also consider purchasing equity (meaning, you get an ownership stake in the business) instead of lending money.
Be careful of start-up loans or loans for funding the next “great invention” that will take the world by storm. These types of loans, although business related, will have an astronomically high default/failure rate.
Lending Money to Family or Friends: The Verdict
Lending money to family or friends is always a dicey situation. If asked by a family member or a friend for a loan, you are almost immediately in no win territory. In the end, it is probably not worth it overall. The risk of losing your money and forever damaging relationship seems to outweigh helping out via a loan.
Every situation is unique though. You must judge the importance of the relationship and decide if it is ultimately worth straining or losing it. I most likely would never loan money to family or friends, but never say never, right?
The ultimate solution: see if you can help out in other ways. For example, if a friend’s car breaks down and they need a loan to get it fixed, then decline to lend money and instead offer rides until he or she can their transportation situated. That way you still lend a helping hand but eliminate money coming between the two of you.
Would you lend money to a family member or close friend? Why or why not? If you have given loans to family or friends, how did it turn out?