“Neither a borrower nor a lender be / For loan oft loses both itself and friend.”

– William Shakespeare

Has a friend or family member ever asked to borrow money from you, rather than seeking out a loan from a traditional bank?

Chances are they have. Every year Americans owe an estimated $184 billion to friends and family members, with the average loan coming out to around $3,200.  Of those surveyed by Finder.com, 1 in 3 respondents have borrowed money in the last 12 months.

These loans can be extremely beneficial. They can help a loved one reach their dreams—or get them through a tough time—and it feels really good to give a hand up to someone in need.

But when personal loans go bad, they can also be a source of tension and hostility that could ultimately ruin an important relationship. 

If you are thinking about lending money to a family or friend, consider the following advice and the possible consequences in order to protect your finances, as well as your relationships.

 

1. Make it Official

 

If you are loaning money to a loved one, set specific terms for the loan that everybody can agree to.

This might feel a little formal and uncomfortable, depending on the type of relationship you have with the borrower and if the loan is needed urgent or emotional reasons. But whatever the circumstances, hashing out the details will help ensure that everyone is on the same page and should ultimately relieve tensions in the long run.

It’s also a good test of the person you’re loaning to. If they are resistant making things official, that might also be a sign that they won’t take the loan seriously, in which case the money you give them, if any, should probably just be written off as a gift.

Discuss the size of the loan, interest rates, and how long they will have to pay it back. You can create an amortization table that will help you calculate the various factors involved with loaning money.

Believe it or not, the IRS actually publishes Applicable Federal Rates (AFRs) that are designed specifically for intra-family lending. They’re published monthly and broken down by the term of the loan (up to 3 years, 3-9 years, and +9 years), so be sure to take a look when deciding what your interest rate will be.

It is a good idea to use the published rates for two reasons. When loaning money to family it can be hard to come up with a fair rate. Using the government’s suggested numbers makes the decision an objective one. The second reason is that the IRS does not allow “sweetheart” deals…or loans with low interest rates.

If you make a loan at a rate lower than the government guideline, it could be deemed a gift instead of a loan.

The IRS tax-free gift limit for 2019 is $15,000; anything that you loan over and above that threshold that is either not paid back or loaned at a rate lower than “market rates” will require you to file a gift tax return come tax time, and could also mean that you, the lender, must pay taxes on the loan.

This can be pretty complicated, so I highly recommend meeting with your financial advisor or tax professional before making the loan.

 

2. Sign the Paperwork

 

Once the terms of the loan have been decided, the next step is to get them written down.

Not only does this make sure that no one conveniently forgets the details that you discussed, but also helps encourage the borrower to take the loan seriously.

In order to make your loan agreement legally binding, both the lender and the borrower must sign documents that outline the specific terms of the agreement. On paper or electronically is fine, just make sure you have documentation of agreement from both parties.

And don’t forget that you’re signing this contract too!

Try not to let a missed payment or breach of contract, even a small one, go by unnoticed. If you don’t think that you’ll be able to enforce the terms of the agreement as they are, consider adding in things like grace periods to help the contract become more flexible.

You can choose to have a lawyer draw up these documents or find a contract template online that fits your needs. Either way, putting the loan down on paper can help to protect your investment and avoid contention among friends and family members.

 

3. Assume You Won’t Get Paid Back

 

If you want to guess whether or not you’ll be paid back on your loan, you might as well flip a coin.

According to that same survey from Finder.com, only 49% of borrowers actually paid back their loan in full. 47% planned to pay it back or made partial payments, while 4% said they never plan to pay it back at all!

I mentioned this earlier, but good rule of thumb with any loan like this is to assume you won’t get your money back, or that repayment will take much longer than expected.

Even if you are loaning money to a financially stable and trustworthy family member, things can happen that prevent them from paying you back as originally planned.

After all, a family member is always the last one to be paid back…falling in line behind the mortgage company, the credit cards, the auto loans, etc.

Prepare yourself for this scenario by not lending anything you can’t afford to lose. This will also help to decrease any tensions that commonly arise in these delicate situations. 

 

“If you would know the value of money, go and try to borrow some.”

– Benjamin Franklin

 

I have made several loans to friends and family and in most cases it ended up to be a win-win.

However, I have had one loan that has not been paid back … and for some reason I have not heard from that friend. In another instance it took much longer than planned and even created some tense moments.

Even though loaning money to a loved one can be beneficial for the whole family, it can also create unnecessary tension and grief. Weigh the pros and cons carefully before loaning your hard-earned money to ensure the financial success of everybody involved.

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CLICK HERE to become an Insider! Join my Email Insider Group to receive weekly tips and tricks on finance, education, home buying, insurance, Social Security and everything in between. Byron W. Ellis, CFP®, CLU®, ChFC®, CRPC®, is a CERTIFIED FINANCIAL PLANNER™ professional and Managing Director United Capital Financial Advisers, LLC, a Financial Life Management firm. The information contained in this article is intended for information only is not a recommendation, and should not be considered investment advice. Please contact your financial advisor with questions about your specific needs and circumstances.

© Byron Ellis