Lending money to friends or family seems like an obvious and easy way to prove you are there for your loved ones. You can show that you understand that life today is expensive as the cost of living continues to increase, and let’s face it, emergencies always spring up.
You are an easy call away and want to help. There's no paperwork or credit checks, and the interest rate is usually zero. Seems pretty simple, right? Nope. It’s not so simple.
What feels like a lifeline can quickly turn into a minefield of emotional tension and broken trust that can cause great schisms, even in the closest of relationships.
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A little help for your friends
It’s challenging to get statistics on how much is borrowed privately, because people don’t have to report these situations. The Federal Reserve does report on national household debt from major lenders, including banks, credit cards, mortgages, etc., but it does not monitor private loans. There are also peer-to-peer lending platforms.
Consequently, clear numbers on this don’t exist. An older study by Finder.com estimated that the Bank of Friends and Family lent $184 billion annually. It also estimated that the average loan was $3,239.
Was the process easy and did the loans get repaid? According to a FinanceBuzz survey, only 56% of lenders were fully paid back by family members. Ouch. A bank would never be in that business.
Even with delinquency rates rising, with a potential recession looming, the Mortgage Bankers Association reports that mortgage delinquencies now stand at a little over 4%. U.S. News & World Report also reports that personal loan delinquencies from financial institutions are at 3.5%.
Pitfalls in a money pit
Just think of the emotional baggage that goes along with friends and family not paying back their loans. How many times does your spouse remind you of the money you lent? How do you pretend to be jovial around the borrowers at the holidays after they’ve stiffed you?
You may cringe when you replay their words. “I need the money for only a few months, and of course I’ll pay it back … with interest.”
Strained relationships may go both ways. The borrower may resent the net worth of the lender and may feel victimized, beholden or patronized. This can all cause divisions within families as one or the other party may feel taken advantage of.
This is all very real. According to the FinanceBuzz survey, nearly 1 in 4 lenders say that giving money to a family member had a negative impact on their relationship with the borrower.
The uncomfortable money dance
It can be an awkward situation for all parties when a loved one asks to borrow money. They may not want to explain why they need it, and they certainly don’t want to beg.
You, as the lender, may also feel uncomfortable. You could be irritated because this may not be the first time you were hit up. You can understand why I call this “the uncomfortable money dance.” We know the steps, but each partner is stumbling over their own feet.
The other result of this is that usually these loans are not documented. Verbal agreements can be sketchy, crushing both parties’ expectations, and lots of phrases can fly, such as “Don’t worry, I trust you,” or, “I promise I need the money for only a month.”
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When a legal agreement doesn’t exist, often the lenders have to resort to discussing a formal agreement later on. And we all know that without written documentation, it’s hard to resolve misunderstandings. In addition to all that, some lenders may lend money they can’t afford to lose.
According to the FinanceBuzz survey, more than a quarter of lenders (26%) had to set up a formal payment plan to get their money back, while 25% reported that lending money led to awkward family interactions and hurt feelings.
How to avoid family loans that lead to family feuds
Set expectations. If you are strapped but want to help, explain that to the borrower. Be clear about when you want the money back, plus all of the repayment terms, such as:
- Will there be an interest charge?
- When and how will payments be made?
- You may also negotiate “gifts in kind.” For example, the borrower could help you with work around your house in lieu of payment.
If you feel more comfortable with giving the money as a gift, with no strings attached, you should make that clear. You don’t want to open the door for them to keep coming back for more.
Don’t enable poor financial habits. Is this situational, or is it habitual? If it’s the latter, it’s time to sit down with the borrower to help them design a workable budget, or recommend going to a financial counselor so that borrowing is not a constant habit.
You might also want to make sure that you are not supporting bad habits such as gambling, drug use or living beyond one’s means.
Put it in writing. Yes, this one could be awkward, but you can explain that your relationship is important and you don’t want any misunderstandings. You can download really simple promissory notes online, or you can access a free loan agreement at LawDepot.com.
A written agreement should outline the loan terms, repayment schedule and any interest, even if it's a small amount. This will make it real for both parties.
Borrowing from friends and family can be a helpful solution in times of need, but it's essential to approach such arrangements with caution and clear communication to preserve relationships and financial well-being.
There is an American proverb that I love: “Before borrowing money from a friend, decide which you need more.”
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