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When friends or family ask us for money, it often puts us in a rather uncomfortable position. On one hand, we want to lend a helping hand to loved ones in need, but on the other hand, what if there are issues of repayment, or you unintentionally establish certain expectations or a sense of entitlement with that loan? With that in mind, let’s examine some rules that that may help you if you find yourself in the position of loaning money to friends of family:

1. Be a pessimist

When you provide a friend or family member with a personal loan, you should be prepared for the worst. This means recognizing the (very real) possibility that person may never pay you back. With that in mind, you may even consider the payment as a gift, rather than a loan. That way, if the loved one is unable to pay you back, your relationship won’t necessarily be damaged. Of course, if he or she is perfectly capable of repaying you and still doesn’t do it, then it could still cause some strife and resentment. That’s why it’s important to go into the loan situation with low expectations so if you do happen to get paid back in a timely fashion, you’ll be pleasantly surprised.

2. Only loan what you can afford to lose

Before you decide to money to friends or family, ask yourself this very important question: “If I were to never be paid back by this person, would it hurt my own finances?” If the answer is “yes,” then you shouldn’t even consider letting him or her borrow those precious funds. To put yourself in financial jeopardy in order to assist someone else is never a smart decision. If you decide you can take the risk of loaning a particular sum of money, however, then make sure you communicate your intentions of providing the loan that to your spouse or partner, especially if you have shared finances.

3. Get it in writing

If you do decide to offer a loved one a loan, it’s important to make it official with a proper contract. This should include the amount that is being borrowed, the amount of interest you’ll charge, and the terms of repayment. If the person to whom you are giving the loan raises an issue with paying interest, simply remind him or her that it’s actually required by the Internal Revenue Service. In fact, if you don’t charge interest, it may be imputed by the IRS and treated as income even if you don’t receive it. For this reason, it’s best to use at least the IRS minimum interest rates.

You may also consider asking for collateral from the person to whom you’re lending, especially if it’s a substantially large sum of money. That way, if the person experiences a major change in his or her financial situation, such as a job loss, medical emergency, divorce, and/or bankruptcy and is unable to pay you back, you’ll still be able to recover your losses. Regardless of the situation, if you are lending a large sum of money, it’s a good idea to ask an attorney review your contract and plan before moving forward.

4. Don’t take it personal.

This goes for both sides. It’s important to realize that when you loan money to a loved one, you’re both entering into a potentially emotionally taxing situation. Before agreeing to the loan, you should discuss how it could change the nature of your relationship should things not go as planned.

For example, if a stranger failed to pay back a loan, it would likely upset you, but those feelings are amplified when it’s someone you know and love. You may feel deceived or cheated by this person. Unless you’re planning on making a financial gift to your loved one, you should enter the loan as a business transaction and treat it as such. Be honest from the beginning with your loved one so he or she knows there isn’t any wiggle room when it comes to your contract.

The bottom line: The act of lending money to family and friends shouldn’t be taken lightly. Before entering into an agreement, weigh the pros and cons and decide whether a providing your loved one a loan is worth the risk of the financial and/or emotional damage it could cause.

Rather than lend money, wouldn’t it be more beneficial to help your loved ones with the underlying problem that got them into financial trouble in the first place? Perhaps you could assist him or her with job searching, or offer suggestions for building up savings. In the long run, this could be much more beneficial than a temporary financial fix.

Ron L. Brown, CFP®

Author Ron L. Brown, CFP®

Ron is a CERTIFIED FINANCIAL PLANNER™ and president of R.L. Brown Wealth Management. He specializes in retirement, estate, and business planning for professionals and entrepreneurs. Ron assists his clients with creating a financial plan to ensure they are able to live their ideal lifestyle during retirement and leave a strong legacy for their family. Ron has been featured in The Wall Street Journal, US News, Yahoo Finance, Investopedia, and numerous other high profile financial publications.

More posts by Ron L. Brown, CFP®

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