If you don’t have the money to pay a few bills, the first thought usually is, “Who can I borrow money from?” In my case, I will naturally turn to my family. However, borrowing money from family and friends, rather than borrowing from a financial institution, such as a bank, comes with a different set of problems. The same can be said when entering any financial agreement with someone you have a personal relationship with. Here are a few things to consider and five reasons why you should not lend money to family and friends.
Reason 1: Loans Tend to Be Open-Ended
It may be extremely uncomfortable to talk about money. As a result, a loan to a family member or a friend tends to be open-ended. The borrower does not know when to pay the loan back and how much they should pay back. In fact, there is tremendous uncertainty for both parties. The borrower does not know when the lender expects payment, and the lender does not know when he or she will be repaid. This may result in a financial standstill for both people.
Instead, consider clearly defining the terms of the loan. This means providing a timeline and repayment schedule for the loan. For example, John will pay you $100 every month for six months starting on April 1st. As a result, the loan will be completely paid off by September 1st.
Reason 2: The Relationship Becomes Awkward
Friendships may become strained when money is involved. When the relationship goes from two friends to a borrower and a lender, it can make things a bit awkward. The borrower may feel micro-managed and that the lender judges everything that he or she buys. This gets even more complicated if other people also know about the loan. People tend to wonder why someone hasn't repaid the loan yet or may become curious about everyone's financial situation.
Instead, the borrower and lender should come to a private agreement about the loan. Moreover, when you spend time together socially and recreationally, try to keep the conversation light-hearted and avoid topics about money and recent purchases. Remember, as long as the borrower is making his or her agreed-upon regular monthly repayments, the lender should not dictate how the other party spends the rest of their money.
Reason 3: You May Be Enabling Poor Spending Habits
While we do not want to judge someone else's reasons for needing to borrow money, nor do we deny legitimate reasons for borrowing money, but lending money to someone with poor spending habits may simply be enabling their poor money management. This becomes particularly apparent if the person asks for more money.
Instead, before you help your friends and family members by supplying funds, have an in-depth discussion about what the issue is. For example, it may be that Susie needs help paying her credit card bill this month, but she may also need to learn how to make a budget to prevent this problem from happening again in the future. A part of the borrower's new budget should take into account any outstanding debt and room for savings. Besides helping the borrower understand and improve their financial situation, this also helps you to clearly see how you will get your money back.
Reason 4: These Loans Actually Cost You Money
For the same reason that I would first turn to my family if I needed money, loaning money to family and friends probably won't make you any profit. This is because family and friend loans don't typically come with additional interest. This is usually why a borrower would turn to you rather than taking out a personal loan from the bank. Thus, you don't earn any money for lending this money.
Unfortunately, this actually costs you money too. If you had invested that money, such as through peer-to-peer lending networks (P2P), or simply left the money in a savings account, you could have earned interest on it.
I will not advise you not to lend money to your loved ones. In fact, that's what family and friends are for - to help you out when you are in a tight situation. However, be mindful that these types of loans actually cost you money and will deny you access to your money if you actually need it. Therefore, never loan money if your own financial situation is tight and never lend more than you can afford. Leave enough money to provide for your family for a rainy day.
Reason 5: It Is Difficult to Ask for Your Money Back
One of the main reasons that financial institutions get their money back on their loans is because of the disastrous repercussions that come with not making the agreed-upon monthly installments. If a borrower fails to pay, the terms of the loan dictate late payment fees, higher interest penalties, and ultimate destruction to his or her credit score. Unfortunately, for family and friend loans, there is no threat of penalties. In fact, the lender may feel so awkward and uncomfortable that they may avoid asking for their money back entirely.
It may be wise to draw up and sign a loan contract. This agreement protects both parties in case there is a disagreement or misunderstanding. The loan contract includes the principal or borrowed amount, the interest rate, if applicable, the repayment schedule, the missed payment recourse, the process of modifying the loan terms, and the process of pursuing legal action for more than three failed payments or loan default, for example. If this loan agreement does not sound appealing, it may just be better to view the loan as a gift and let go of any expectation to be reimbursed. As a result, never loan any money that you cannot simply give away. This is the best way to preserve relationships without putting yourself in financial straits.
Lending money in cash is ideal. Never give someone else access to your credit cards or co-sign a loan. First, this protects you so that someone else's actions do not affect your credit score if they fail to repay the debt. Second, this keeps your credit utilization low by not allowing someone else to run up your outstanding credit card debt. Third, it keeps your Total Debt Servicing Ratio or TDSR low so that if you need to take out a loan, someone else's loan does not disqualify you.
It is not financially advantageous to loan family and friends money. However, we do it because they are our loved ones and we want to help. Nonetheless, there are risks involved and reasons why we may simply want to deny the loan request altogether. On the other hand, if you can afford it, you may consider loaning the money, with the worst case scenario being "gifting" the loan amount, to help someone in need. Alternatively, you may be able to help in more practical ways, such as purchasing groceries or caring for familial responsibilities so that the potential borrower can work a little more instead. Lending money to family and friends may not be the best financial decision, but with clear communication and an explicitly drawn-out repayment schedule, both parties may be able to see the way out.