Lending money to a family member or friend is a kind gesture. And it appears to be a growing trend throughout North America. According to the Federal Reserve Board’s Survey of Consumer Finances, loans from family and friends amount to US$89 billion a year in the United States. In Canada, a poll conducted by Abacus Data found that one-third (34%) of adults have borrowed money from family or friends at some point in their lives – whether to pay university tuition, make a down payment on a house, or cover an unexpected cost and bridge them to their next paycheque.
But is it ever a good idea to lend money to a family member or friend? While there’s no question that it’s nice to help someone in need, there is a significant amount of risk involved in doing business with a relative or friend. Once you enter into a financial transaction with someone close to you, it inevitably changes your relationship – and not always for the better. If loans are not repaid, it can cause tempers to flare and lead to fractures in friendships and disrupt family dynamics. Relationships can be permanently damaged.
Fortunately, there are a number of steps you can take to ensure that, if you do lend money to someone you know personally, the money gets repaid and there are no hurt feelings involved. Samuel Chinniah is Senior Vice President, Family Office Services, at T.E. Wealth. He regularly advises clients on the “dos” and “don’ts” of wealth management, estate planning and retirement preparation. Inevitably, he is asked about the best ways to lend money to family and friends. Here are some of his insights gleaned from years of experience.
1.Consider the person who is asking for money
The first thing you should do is give consideration to the person who is asking for a loan. How well do you know them? Have they asked you for money before? Is the person someone who consistently lives beyond their means? If you lend them money this time, will they ask you for money in the future? And, perhaps most importantly, is the person trustworthy? Scrutinizing the person who is asking for money is the first step in analyzing whether giving them a loan would be a good decision.
“Help rendered to someone in their hour of need is always a good thing to do,” says Mr. Chinniah. “But the reality is that some people always live beyond their means. Ask yourself if this person has spendthrift issues. The last thing you want to do is become an enabler.”
2. What is the purpose of the loan?
The next thing to consider is the purpose of the loan. Is it in alignment with your values? According to Mr. Chinniah, making this distinction will help you determine whether or not to move forward with the loan.
“If you think it is a worthwhile endeavour to support, then it probably is,” says Mr. Chinniah. While some may consider education or starting a business to be meaningful pursuits, others may see value in helping a family member out with a loan for a car or money to buy equipment. The key is to be comfortable with the loan. If it doesn’t feel right, it probably isn’t in alignment with your own values.
3. Pay attention to red flags
When it comes to making a loan to family and friends, there are often red flags visible for people who choose to see them. Many people who turn to relatives or friends for a loan do so because they’re unable to get a traditional loan from a bank. And many people who look for personal loans have done so in the past. Mr. Chinniah advises to watch for “habitual offenders,” those people who have a history of borrowing money from loved ones and close personal friends. An obvious red flag is if the person seeking a loan has a history of failed investments, business ventures or other schemes. Another red flag is if the person has borrowed small sums of money in the past and is now looking to borrow larger amounts.
“Past behaviour is usually a good predictor of future conduct,” says Mr. Chinniah. “Do a credit check on people and find out their current debt levels and credit score. Be vigilant.”
4. Put the loan agreement in writing
Verbal loan agreements between friends and family can be risky for a number of reasons. Expectations regarding a repayment plan may not be clearly communicated, and details of a verbal agreement can be left open to interpretation. For these reasons, Mr. Chinniah says that it is always best to put a loan contract or agreement in writing, ensuring that it has clear terms of reference. You can also have a promissory note drawn-up, which is a signed legal document containing a written promise to pay a stated sum of money to a specified person at a specific date or on demand.
“You should treat a loan as a business arrangement, even when dealing with a family member or close friend,” says Mr. Chinniah. “Be careful about taking people at their word. Don’t leave the details to chance. Put it in writing.”
5. Charge interest on the loan
“If there’s no cost, there’s no commitment,” says Mr. Chinniah. For this reason, it’s a good idea to charge interest on any personal loan you make. If you don’t charge interest, then the person receiving the loan may feel that you’re not taking the financial arrangement seriously and they may also take the loan lightly. By charging interest, people borrowing money know that there’s a cost to them if they fail to repay the loan.
“Interest ensures that a loan is treated with importance,” says Mr. Chinniah. “Consider when you pay your monthly bills. Most people focus on paying the bills with the highest interest, or greatest penalty, first. You likely prioritize paying off your credit cards because they carry a high interest rate. That interest rate makes you take the credit card seriously.”
Keep in mind that if you do charge interest on the loan, you’ll need to include it as income on your tax return. The Government of Canada posts a prescribed interest rate on a quarterly basis, which can be used as a guide for the interest rate to charge.
Mr. Chinniah adds that you can return the interest amount that you’ve collected on a loan to the person who borrowed money from you. But he advises doing so once the principal amount of the loan has been repaid in full, and not before. You can waive any accrued interest as a gesture of thanks once the loan is settled.
6. Ask yourself if you can afford to lose the money you’re lending
One of the final things to weigh when considering making a loan is whether you can afford to lose the money you’d be giving to a family member or friend. If the loan were to never be repaid, would you still be alright financially? Loans that involve some form of collateral, such as a house or vehicle, are generally safer than loans made for less tangible things such as a tuition payment or vacation. Be sure to factor your own financial situation into the equation.
“If you can’t do without the money, don’t make the loan,” says Mr. Chinniah.
7. Protect the personal relationship
Lastly, take steps to protect the personal relationship you have with a loved one or friend. Don’t let money cause irreparable harm to a valued relationship. By setting clear expectations, putting the terms of a loan in writing, charging interest, and giving full consideration to the person you are lending money to and what the money is to be used for, you can retain a strong and positive relationship with the person you have lent money to. Most importantly, have the courage to say “no” when asked to lend money – even if it is to a relative or friend.
“The biggest risk is the loss of a relationship,” says Mr. Chinniah. “Money has a way of tainting relationships. A loan arrangement can strain a relationship and it is never the same again. Everyone should take steps to ensure this doesn’t happen. It’s not worth it.”
Joel Baglole is an independent financial writer.
This article was published in T.E. Wealth’s Strategies newsletter, June 2019 edition. Read the full edition here.
These articles are for general informational purposes only. Please obtain professional advice before taking any action based on this information. No endorsement or approval of any third parties or their advice, information, products or services should be implied by any references to third parties contained in any article. Trademarks cited in these articles are the respective properties of their owners.