Ever have a friend or family member ask for a loan? It can be awkward, and for many the knee-jerk reaction is to just pull out the checkbook. But having the funds available to extend a loan is often not the point when it comes to lending money... it's knowing when or if you will ever receive your hard earned funds back.
According to a Federal Reserve survey, over 8% of Americans have loans that have been extended to friends and family. By some estimates, these loans total a whopping $89 billion and an eyebrow-raising default rate of 14%, versus just 1% for those who borrow from a bank. So before you decide to play banker with your friends and family, consider these steps to help avoid a potentially ugly situation.
Don't Commit Right Away. When asked for a personal loan, don't say yes right away, especially if the sum of money is large. It has been said that "quick to borrow is always slow to pay." So while you want to show compassion for the friend or family member and tell them you would like to help, explain that you need a few days to review your financial situation and make a decision. Perhaps another solution will come to them in the meantime.
Just Say No. If possible, try to avoid lending the money. Statistics suggest that the risk of not getting repaid is very high, which could be damaging to your relationship. HOWEVER... before you blurt out a blunt "NO," consider the amount requested, provide an explanation that will not hurt your relationship, and offer to help in a non-financial way. Or consider giving a smaller amount as a gift, with no expectations of repayment. This allows you to be generous on your own terms, and removes the potentially heated issue of non-repayment.
Be Specific. If you do decide to extend a loan, sit down with your friend or family member and set expectations. And don't beat around the bush... be very specific about the term of the loan, interest rate, payment plan, even the penalty that will be incurred should a payment be missed.
Get It In Writing. Always put the terms in writing. Seven out of ten personal loans are not put in writing... but again, consider the markedly higher default rate of non-documented loans. A written agreement reinforces that you are serious about the repayment terms discussed, and it prevents any potential misunderstandings. Promissory notes can be purchased online at www.nolo.com for a reasonable price. If the loan is large or complex it may be most beneficial to have an attorney draw up an agreement. Make sure the loan papers are filed away in a safe location, and then keep good records.
One important note, if the loan is in excess of $10,000 or the money will finance income-producing activities, the IRS expects you to charge a certain amount of interest...and claim it as taxable income, of course. To find the current rates, visit www.irs.gov and search for AFR (Applicable Federal Rates). You can also contact your trusted CPA for advice--or if you don't have one, ask me--I may be able to provide a referral.
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