Lending money to a friend or relative? Many folks will tell you, "Don't do it." Or at least never lend more money than you can risk losing. Unless you clearly define the terms of your loan at the outset, you may just as well have called it a gift and called it a day.

Think that attitude is overly cynical? Watch People's Court or any one of the other reality courtroom shows on TV. Their dockets are chock-full of cases in which personal loans have gone awry -- and those are just from the folks willing to air their dirty laundry on national television. When you consider what's at stake with a "loan" that's mishandled on either side -- lost or damaged relationships, tension in a family or group of friends, and disintegrating finances -- you'll know to take the personal lending process very seriously.

Here's how to ensure that your loan stays a loan -- not a gift:

  • Clearly indicate that you expect to be paid back. Along with this, set the expectation of when you expect repayment to begin, how often you expect payments, and in what amount. You'll also want to discuss how you would like to handle late or missed payments and whether your loan recipient has any collateral.
  • Seek tax advice. Many folks who lend money to loved ones are loath to collect interest, but not doing so can leave you in hot water with the IRS. Get the advice of a tax professional regarding how much interest you should charge to avoid a sticky wicket called "imputed interest." Basically, the IRS defines a loan as a transaction that involves interest -- so even if you don't collect it, the IRS will assume a "reasonable rate" and then hold you accountable for paying taxes on it. Yikes.
  • Get it in writing. You don't want to be stuck down the line in the midst of a "he said, she said" argument. A contract signed by both parties (and preferably witnessed) is a great way to ensure that the lending terms are clear.
  • Enlist the help of a third-party service such as Virgin Money to add the proper degree of formality to a personal loan. With Virgin Money's personal-loan programs, Handshake Basic and Handshake Plus, you still have the benefit of playing Mr. Nice Guy to friends and family while protecting your money. An interesting wrinkle: Virgin Money will report the borrower's repayment history -- good, bad, and ugly. On the plus side, you could help loved ones repair their credit ratings.
  • Know when to say no. It can be awkward to meet a loved one's earnest request for money with a flat-out "No." But lending isn't a responsibility that's set in stone. If you simply don't have the means to offer assistance, if lending will cause you undue anxiety, or if you can feel your resentment growing at the mere mention of a loan, then "I'm sorry. I can't" is the best response you can give.

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Fool contributor Elizabeth Brokamp is a licensed professional counselor who regularly talks money with her honey, Robert Brokamp, editor of The Motley Fool's Rule Your Retirement newsletter and co-advisor of Motley Fool Green Light. The Fool has a disclosure policy.