When times are tight, often the quickest path to some much-needed cash is through a loan from a friend or a family member.
According to Boston-based American Consumer Credit Counseling (ACCC), 82% of all Americans would help a family member financially. Younger family members are especially generous, with 92% of individuals aged 18-34 saying they would loan cash to a family member in financial distress.
It’s hard to refuse a family member’s request for a friendly loan, but be sure to go into such arrangements with your eyes open (and maybe your wallet closed).
High Cost of Family Loans
According to the ACCC, total loans between family members totaled $89 billion in the U.S. in 2013 (the most recent number available), with 15% of family lenders not expecting the money to be paid back. Even if the family member knew beforehand that the money wouldn’t be repaid, he or she would provide the loan anyway.
“Americans are turning to friends and family for loans rather than the big banks to avoid spiraling into more debt and defaulting on regular payments,” explained Steve Trumble, CEO of ACCC. “Even though consumer and student loan debts have each surpassed the trillion dollar mark, young Americans are still the most willing to help out friends and relatives in need, which could exacerbate their own debt as well.”
The key to lending money to family members – especially if you expect the money to be repaid – is to treat the deal like a business loan and keep emotions out of it.
“By treating loans between family and friends as a business transaction, consumers can safeguard themselves from damaging an important relationship because of money,” Trumble added. “Although you might feel inclined to help out a loved one with finances, it’s important to openly communicate about repayment expectations so that no one is left in the dark, or worse: in the red.”
Steps to Take
Taking a business mindset to a family loan is just the beginning of ensuring the process doesn't ruin relationships. Experts advise taking the following steps before extending financial support to family members:
1. Don’t expect to get the money back – Go into a family loan situation with a mindset that you’ll never see the money again. That’s not saying you won’t – it’s just that if and when the loan does go un-repaid, you won’t be as disappointed. “There are no such things as loans among family and friends – they’re gifts,” says Mary C. Kelly, Ph.D., and the author of the book “Money Smart.” “They are a gift if you give or receive them and they are a gift if you get paid back.”
2. Expect slow re-payment – Kelly says that the nature of a family loan – with no professional obligations attached – changes the loan dynamic. “The reason people need loans from friends and family is because they typically cannot get a loan anywhere else,” she explains. “The financial institution won't give them a loan or if they do, the interest rate will be too high to be helpful.” She says that borrowers of money from family and friends don’t view these loans as seriously as they do those from banks, so they are far more casual about returning the money. It’s a no-win situation, Kelly notes. “With close family and friends you really cannot demand collateral or interest payments and expect to keep a good relationship.”
3. Make a checklist – Kevin Murphy, a senior financial consultant at McGraw-Hill Federal, a New Jersey-based credit union, advises putting together a checklist if you plan on lending cash to a family member.
“Sometimes an individual may have no credit history or may have damaged his or her credit so severely that they will need to seek other alternatives,” he says. “A lot of times this member will have no choice but to approach a family member for a loan. I always recommend to friends and the family members to approach this as a business transaction.”
Consequently, if you’re the family member or friend being asked to lend the funds, here is an important checklist of questions to be answered before you lend:
- Has this person asked me for money in the past?
- If so, was I paid back?
- Was I paid back in a timely manner?
- What is the likelihood that I will be paid back this time?
- What are the funds to be used for?
Another important question you will need answers to is: How do you plan on paying the loan back? “This is extremely important because most have good intentions,” Murphy adds. “However, if their income is already accounted for paying all their other obligations, where will your 'promise' come in?”
Murphy says having paperwork in place holding both parties accountable can mitigate many of the problems linked to family loans. “Just make sure the contract covers the all-important question of payments, particularly what happens if the loan goes unpaid,” he says. “You may need to develop a couple of different repayment contingencies to provide for different scenarios.”
4. Remember the IRS – Be aware that the IRS has a $14,000 gift tax rule. A small loan will travel under the radar, but if you don't charge interest on a loan of that amount or more, it may be considered a gift. Click here for more information.
Last and Definitely Not Least
If you’re married or in a relationship where you’re sharing a bank account with a spouse, make sure that spouse is on board with your decision to lend money to a relative.
“If you lend a family member money, you can cause a strain to your cash reserves, but much more importantly, to your marriage,” Murphy adds. “This is crucial. If approached, make sure you involve your partner right away.”
The Bottom Line
There’s no guarantee a family loan won’t bring disappointment and conflict, but that won’t stop us from helping the people we love the most. If you agree to lend money to family, make sure to set expectations, draw up a contract and make sure your spouse is aware that the loan is happening. For more, see 8 Ways to Help Family Members in Financial Trouble.
A measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow (FCF) represents ...
Any ratio used to calculate the financial leverage of a company to get an idea of the company's methods of financing or to ...
A type of compensation structure that hedge fund managers typically employ in which part of compensation is performance based. ...
The total dollar market value of all of a company's outstanding shares. Market capitalization is calculated by multiplying ...
A measure of what it costs an investment company to operate a mutual fund. An expense ratio is determined through an annual ...
A hybrid of debt and equity financing that is typically used to finance the expansion of existing companies. Mezzanine financing ...