Polonius had it right, for the most part. In “Hamlet,” he advises his son not to borrow or lend money because “loan oft loses itself and friend.”
That said, it’s hard to say no to the people closest to you. When they need help, if you are in a position to provide that help, the emotional bond you’re risking makes it really difficult to deny it.
If you find yourself in that position, there are some better and worse ways to go about it. Doing it right can mean forging an even deeper and better bond with the people you love; doing it wrong risks just what Polonius warned about: losing that friend, and the money you loaned them.
7 Strategies to Consider When Lending Money to Family and Friends
1. Lend Only What’s Needed
Before you seriously consider lending money to friends and family, first find out how badly they need the loan. Never lend a buddy more than the price of a meal for something that’s not essential. If they lack the financial discipline to save for whatever it is they want money for, it’s a huge red flag indicating that they’re unlikely to pay you back as promised.
This rule doesn’t just apply to whether or not they need the thing they want to buy. It’s a good idea to help your friend or family member brainstorm ways they can accomplish their goals without borrowing money. Maybe you have skills or time you can lend them instead of cash. For instance, you could help them come up with less expensive ways to get what they want. Maybe all they need is a second set of eyes on their situation to help find a plan that works, without going into debt.
Bottom line: Don’t lend them money unless it’s necessary.
2. Start With a Plan
Friends and family loans are the loans people are the most likely to default on, in part because friends and family won’t slash your credit rating — but also because most friends and family loans are informal. The lender hands over some cash and the borrower promises to pay it back, but nothing else is set up to keep the borrower accountable. This can lead to slower payments or no payments at all, dulling the edge of your relationship as one party gets embarrassed and the other gets resentful.
Instead, start the loan with a detailed arrangement of how it will be repaid. When is the repayment due? Will there be installments? If so, when? When you’re making the plan, find out what will change in the borrower’s financial situation to allow them to make those payments on time.
Bottom line: If you set up the loan like a regular business transaction, the borrower will be more likely to treat it with the importance and urgency of a traditional loan.
3. Charge Interest
Not every person feels comfortable lending money at interest to friends and family, but even a small interest rate can keep things feeling businesslike, add urgency to the borrower’s repayment schedule, and help the lender feel a little better about the whole situation. Before lending money, make a reasonable interest rate part of the plan you set for the loan repayment.
“Reasonable” varies from person to person. You don’t want to gouge the borrower, but you don’t want to charge too little interest, making it an ineffective motivator. Two of the most common and useful ways to set the rate include:
- Set the interest rate to match what the money would be earning in your investment accounts. For example, if you took it out of funds for a 2.5% CD, charge 2.5%.
- Give a discount compared to what the borrower would pay by borrowing the money from a bank. For instance, if their best offer was a line of credit at 12%, cut it in half and charge 6%.
It’s also reasonable to increase the interest rate after a certain date, raising it by 1% to 2% if the promised payoff date passes and the loan isn’t repaid.
4. Set Up a Default
This strategy comes in two parts. First, before you even consider lending the money, run the numbers, and see what will happen to your financial situation if you never see that money again. Second, come up with a plan if the lender defaults on the loan.
For the first part, just run your personal budget for the coming year and make sure you can afford to lose the loan entirely (more on that later). Do this on your own before the conversation even begins with your friend or family member.
For the second part, sit down with the person asking for money and ask what they will do if they can’t repay you. Don’t take “I’ll pay you” for an answer. Things could change. Come up with a mutually agreeable plan for what will happen if they can’t pay you back. Can they offer collateral? Can they come “work off” the debt by mowing your lawn or babysitting? Get creative.
5. Get Paid First
If you’re setting up an installment plan for repayment, set the due dates for each payment as close to the borrower’s payday as you can. It’s easy for people to get paid, cover their bills, have a little fun, then not have enough money left to pay you back.
By contrast, if you make sure they’re paying you as soon as they get their check, it will be their luxuries and discretionary spending that takes the hit. They might buy fewer beers or miss that one concert, but your loan — and your relationship — will be safer.
6. Write it Down
None of what we’ve talked about so far does much good if it’s all a verbal contract. People often remember things (especially details like dates and interest rates) differently. Worse, if one person’s memory is different, things could get stressful, and the relationship could suffer tremendously as a result. Misunderstandings related to money can escalate an already tricky situation into seriously bad blood.
You don’t need a formal contract, but a bullet list in a Word document or Google document — where people can look up changes by date and who made them — can cover all the bases. Make sure the document includes at least the following:
- The original loan amount
- The rate of interest
- When interest accrues
- Each expected pay date
- The amount expected at each pay date
- What happens if a payment date is missed
- What happens if they default on the loan
This gives you a written record of your agreement, and you can reference it any time there are issues with the loan.
7. Keep Your Distance
With a loan in place, it can be tempting to watch the borrower’s spending and buying habits until you get your money back. This is never a good idea. It builds resentment on both sides, with you getting mad if the borrower spends money on optional extras, and the borrower getting resentful that you’re in their business.
Step back and remember to treat this loan as a business transaction. Your bank and credit card company don’t try to shame you because you had two beers with dinner or bought a new car. They just collect their money and remind you if you miss a due date.
It’s fine to ask about payments when they’re late or even to check in and make sure they can make the first few payments on time, but otherwise, don’t mention it. Keep that part of your relationship separate.
One last thing to keep in mind: never lend money you can’t afford to walk away from. There’s an old saying: “If you lend somebody $100 and never see them again — that’s money well spent.”
Losing a loan of some spare funds you had lying around is disappointing, but doesn’t harm you. However, losing money that you were counting on for later, or counting on a loan repayment by a specific date, sets you up for serious harm both to your financial situation and your relationship with the borrower. If you can’t afford to lose the money, you can’t afford to lend it.
Have you ever loaned money to a friend or family member? What are your tips?
Brian Smith is a freelance writer and personal finance guru. He writes about money, entrepreneurship, and living the good life for dozens of companies. He lives and works in Grand Rapids, Michigan.