Why You Shouldn’t Lend Money to Family or Friends

Probably every one of us – at one time or another – have been confronted with a decision of whether or not to lend money to family or friends. Though I have never seen a survey confirming this, I have a strong suspicion that most people who have gone ahead and made the loan saw it come to an unhappy end.

The time-worn warning has always been never do business with family or friends. That’s probably been one of the most bankable “old sayings” ever to make the rounds. The problem is compounded now by the fact that so many people are struggling financially and, due to tighter lending restrictions, they are unable to get traditional bank loans.

If you are confronted with the decision to lend money to family or friends, be aware of the unique potential problems that are involved, and – more importantly – how to avoid them.

1. The terms are usually too soft or non-existant.

This is one of the biggest snags when making loans to family or friends. The loan is typically based on nothing more substantial than a handshake or a “gentleman’s agreement.” Not only does this open the floodgates to misunderstanding, but it also provides no basis to seek legal remedy in the event of nonpayment.

As much as we may find it distasteful, there are very solid reasons why bank loan agreements come with so many specific provisions and so much “legalese.” It’s all to protect the bank.

If you are going to make a loan to a friend or family member, you need to do much the same. You probably can find standard form loan agreements somewhere online, or even at a business supply store. It would be well worth investing a few dollars in using one of these forms to frame out your loan agreement.

If the person you are loaning money to objects to the terms – or to the whole use of a written agreement itself – you can probably take this as a sign that the loan is heading for trouble. Better to find that out before transferring the funds!

2. You might become the collection agent.

Both you and your borrower friend will be all smiles the day you make the loan. But in the event that repayment comes slowly or not at all, you’ll be put into the very uncomfortable position of having to ask for the agreed-upon payments. Not only will you feel stress in asking for the money, but the friend or family member you loaned money to could become overly defensive at your approaches.

Having a written loan agreement will help by spelling out the terms of the expected repayment. In addition, it may be helpful if you emphasize – over and above the written agreement – why you need to have the payments when due. You must be unequivocal on this point! Even so, this will not prevent late or non-payments as a result of the borrower’s inability to pay, but it will make clear that repayment is expected, and expected at regularly scheduled intervals.

3. Your relationships might dissolve.

Anytime you make a loan to family or friends you have to be fully prepared for the possibility that the money may never be repaid, and that can be a real relationship killer. This is a risk that you take any time you lend money to family or friends.

But there are three ways that you may avoid this outcome – not the unpaid loan, but the ruined relationship:

1. When you make a loan to a family member or friend, be prepared to convert the loan to a gift. That will cement the fact that you will not be repaid, but if it will save the relationship, it may be well worth doing.
2. This is a corollary to the first point – never lend money to family or friends that you are not fully prepared to part with forever. This will keep you in a financial position to forgive the debt if need be.
3. Only lend money to a family member or friend if it will solve a clearly identifiable and temporary problem.

The third point needs more explanation. If you are going to lend money to family or friends to cover an unexpected medical bill, this is probably an acceptable reason to make a loan. The bill is a one-time event, and won’t create a series of obligations that will keep the person in perpetual financial distress.

But if the person asks for money to make the mortgage payment on a house that they cannot truly afford to keep, the loan will be a classic case of throwing good money after bad. Your loan may keep them in the house for another month, but eventually they will lose the house for the very same reason they needed to borrow money from you in the first place.

The purpose of the loan does matter, and you should feel free to decline the request if you are not satisfied with the reason, or don’t believe that will truly fix anything in their lives.

4. You might need the money before it is paid back.

No matter how much you want to help someone else, you have to consider the impact that making the loan will have on your own financial position. If the loan – and the failure to obtain repayment – will put you into financial distress, you will eventually need to borrow money from someone else. You’re not helping a loved one if by doing so you’ll be putting your own situation in jeopardy.

It’s worth reemphasizing that you should never loan money to family or friends that you cannot afford to lose yourself.

5. You could be opening the door to more loans in the future.

I think that it was Ann Landers who first said, “No good deed ever goes unpunished.” While I admit that I’m not entirely comfortable with that whole philosophy, it is also a self-evident truth when it comes to loaning money to family and friends.

Make a loan to a family member or friend, and there’s one thing you can guarantee: either that person – or someone they know – will come to you in the future for yet another loan.

In your circle, you may even come to be viewed as “the one with the money.” The very fact you can make a loan to another person will confirm this fact to other people.

Unless you are fully willing and able to make additional loans, the best way to avoid this fate is by pledging the borrower to absolute secrecy about your loan arrangement. Feel free to tell them the reason why you don’t want to disclose it to others. You can also explain that you are unwilling to make future loans – to them or anyone else.

Just because you’re making a loan once doesn’t mean you’re going into the banking business! The borrower should fully understand this, and be willing to keep whole arrangement under wraps.

Have you made a loan to family or friends? How did it turn out?

Kevin Mercadante is professional personal finance blogger, and the owner of his own personal finance blog, OutOfYourRut.com. He has backgrounds in both accounting and the mortgage industry. He lives in Atlanta with his wife and two teenage kids and can be followed on Twitter at @OutOfYourRut.

All posts by Kevin Mercadante