Lending to family and friends has been going on since the first money was minted. Is it a good idea? That depends on who's doing the borrowing and who's doing the lending.
We’ve all been there: either asking for a loan from family or friends, or being on the receiving end of a loan request.
These days it wouldn’t be surprising to find the practice even more widespread. With banks paying basically nothing, lending money to a trusted friend or relative isn’t just a nice thing to do. It could be a smart thing to do.
And that leads us to this week’s question:
At dinner the other night, friends were talking about their daughter in law school. She was complaining that interest on the money she needed to borrow for the coming year would be 7 percent. Her dad said, “Talk to Grandpa. He’ll lend you the money for 3 percent.” My spouse piped up with “For 3 percent, I’ll lend her the money.” I can think of some pros (we are getting no return on our cash) and a lot of cons (we’re not a bank). What does Stacy think?
Before we get started with the answer, check out a video I did about this topic back in 2008. While some of the information in it is no longer accurate — Virgin Money no longer exists — the principles it describes are still airtight.
While Virgin Money is no longer an option, similar services allow you to formalize loans to friends and family. But let’s go back to our question.
Is lending money to family, friends or anyone else a good idea?
If I had to give a one-word answer to this question, I’d simply say “no,” for the reason offered by Shakespeare: “Neither a borrower nor a lender be; for loan oft loses both itself and friend … .”
But a full answer is more complicated, because it depends on who’s doing the borrowing, who’s doing the lending and how well the loan is documented.
Who’s doing the borrowing?
With savings rates hovering near zero, making loans to friends, family or even strangers (peer lending) can make financial sense. But to make it work, you have to think like a banker.
I’ve lent money to many friends over the years, from $50 to $50,000. Almost without exception, these loans became a nightmare. The reason? The people doing the borrowing were either unwilling or unable to pay the money back according to the terms they originally proposed.
Here’s how bankers look at borrowers, and you should as well:
- Decent candidate for a loan — someone who doesn’t need the money all that much.
- Good candidate — someone willing to put up collateral that exceeds the value of the loan.
- Better candidate — someone with an extensive track record of repaying debts on time and as agreed upon.
- Ideal candidate — someone with all three of these qualities.
So, my question to those considering a loan to our law school student: How good a candidate is she?
Who’s doing the lending?
When you’re a banker lending to strangers, you’re careful whom you lend to and you’re relentless about getting repaid. You’ll use every legal remedy available to get your money back, from dinging the borrower’s credit to suing them to court.
But if you’re an individual who is lending to a family member or friend, you’ll likely be reluctant to pursue remedies available to you. This is the crux of the family/friend loan dilemma: There’s little you’ll do if the borrower defaults, and the borrower knows it. Often, the goal is no longer getting a return on your money but rather getting the return of your money.
So if you’re a lender who’s not all that concerned about being repaid — some grandparents might fall into that category — by all means, become a family banker. Just go into it with your eyes open.
But if you’re the type who not only expects to be repaid, but needs to be, think hard. What will you do if the borrower doesn’t meet her obligations? It’s unlikely you’ll be able to threaten her credit score. Will you send her debt to collections or take her to court?
If the answer is no, you’re ultimately at her mercy.
No matter whom you’re lending to or what kind of lender you are, always do this
Write down the amount, the interest rate, when it’s due, the collateral and what’s going to happen if the terms aren’t met.
Having endured countless bad loans to friends and acquaintances over the years, I’d sooner chop off my own foot with a dull ax than lend money to anyone, family or not, without doing this.
Do anything else, and you might as well consider it a gift.
You can easily find a standard contract online. Have both sides sign it, and you’re miles ahead of a verbal agreement. If the amount is large, have an attorney do it for you.
Will a written agreement guarantee you’ll see your money again? No. Even if you properly dot all i’s and cross all t’s, legal remedies won’t do you any good when you’re reluctant to use them. But at least that agreement will let the borrower know you’re serious.