3 Golden Rules of Lending Money to Loved Ones

A famous line from Shakespeare's Hamlet says, "Neither a borrower nor a lender be." The reason? It puts a strain on relationships, particularly as people don't always pay back that money. But money lending is one of the oldest professions in the world because there are times when people need to borrow. And sometimes friends and family are their only option.

If you're considering giving or taking a loan to or from a loved one, you're not alone. Over 50% of American households either borrowed or lent money to friends and family last year, according to data from the Consumer Financial Protection Bureau. Speaking personally, I've lent money to loved ones on several occasions with varying results. If you're going to make that loan, these golden rules could help protect your relationship. 

1. Talk about why the loan is necessary

There can be all kinds of reasons why someone might need a little help. Perhaps they lost a job or have a medical issue and don't have any emergency savings. Maybe they aren't great with money and this isn't the first time they've borrowed from you or others. Find out whether they've tried to take out a personal loan and why they are turning to you. Perhaps they don't have strong credit or have already maxed out other options.

If someone you care about has already exhausted other options, you might be saving them from taking a payday loan with crazy interest rates or borrowing from another unscrupulous lender. If you have enough money in the bank, that's a powerful thing to do. On the flip side, know that there's a chance you won't see your cash again. Especially if you lend it to someone who's often behind in their payments.

Depending on your relationship, try to talk openly about finances. If the person who needs money doesn't have a budget, perhaps you can encourage them to make one. If they've also got credit card debt or other commitments, ask them how they are going to keep on top of their various repayments. If you do it sensitively, this might be a chance to help someone you care about change the way they handle money.

2. Only lend what you can afford to lose

Loaning money is a lot less stressful if you don't need that cash and won't be impacted if the loan doesn't get repaid. That isn't to say you shouldn't hope to get it back. But think of it like helping someone who's drowning -- there's no point in you diving in to help only to get dragged under as well. 

I find it helps to mentally treat loans as gifts. It means I only lend money I'd be prepared to gift (and lose). It also reduces the potential for irritation if something goes wrong. Even then, it's incredibly annoying to lend someone money only to see them buying new clothes and planning a vacation rather than paying you back. But once you make that loan, it can be awkward to complain.

Everybody has a different concept of what they can afford to lose. And a lot depends on who it is that needs the money. For example, some people might be willing to dip into their emergency savings to help their child, others may not. Ultimately, if you are doing OK with your financial goals and have a steady income, you're in a much better position to make a loan than someone who's only just keeping their head above water. 

3. Be clear -- get an agreement in writing

It's amazing how much gets glossed over in verbal agreements or how two people can leave the conversation with a different view on what was said. Not only can documenting the loan give you something to refer back to, the process of getting things in writing can help ensure everybody's on the same page.

You might download a template online or make your own from scratch. Here are some items to include:

• Date of the loan
• Amount of loan
• Interest rate (if any)
• How the repayments will work, including payment dates
• What will happen if payments are missed 

There may also be tax implications for your loan, particularly if it's for a significant sum of money. For example, if you write off that loan at a later date, the IRS might consider it a gift. Similarly, if you don't charge interest, those waived interest payments could well come under the gift umbrella.

Bottom line

Given that many people don't have an emergency fund to cushion against unexpected financial shocks, the ability to borrow from loved ones could be a lifeline. Unfortunately, it can also be stressful for everybody involved. If you don't feel comfortable making the loan, it's OK to say no. And if you do go ahead, the steps above may help reduce the potential for emotional fallout.