Should You Loan Money to Family or Friends?
Mixing money with family or friends can make for a complicated situation.
When a close friend or family member asks you for money, it’s tough to know what to say. You may find yourself going over every possibility in your head. Can I afford it? Do I have to worry about them paying me back? Is it going to be awkward if I say no?
In this type of situation, you don’t want to lose money, but you probably also want to avoid jeopardizing your relationship with the other person. To accomplish both of those things, you’ll need to be aware of the potential repercussions and how you can figure out if the borrower is loan-worthy.
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Why lending people money can go horribly wrong
Some people believe that loans between family or friends are never a good idea, and it’s easy to see why. There are several reasons this nice gesture could backfire for you.
You could lose the money. Let’s start with the worst-case scenario. The borrower may not pay you back, either because they can’t, because they decide they don’t care about paying you back, or because they suddenly get the idea that this money was a gift, not a loan.
Those scenarios may not seem likely, but watch some "Judge Judy" and you’ll see that they occur all the time.
There’s little incentive for the borrower to pay you back promptly. When people borrow money through personal loan providers, they have plenty of motivation to pay on time. If they don’t, they could end up with late fees and a lower credit score.
When you loan money to someone, they don’t need to worry about that. They can forget to pay you without much consequence besides saying sorry. And you’ll be in the uncomfortable situation of playing debt collector when you remind them about it.
You may be enabling their bad financial habits. It doesn’t mean that someone has bad financial habits just because they ask to borrow money, but it’s a possibility. A lot of people aren’t good with money, and they’re less likely to learn if they can get an interest-free loan with a flexible term anytime they need it.
One loan could lead to requests for more. Even if everything goes smoothly with a loan, it could still result in trouble for you later. If the borrower needs money in the future, you could become their lender of choice, simply because you said yes the first time.
Evaluating whether you should give someone a loan
There are two steps to deciding whether to lend another person money: seeing if you can afford it and evaluating the potential borrower.
First, you need to figure out if you can afford the loan request. Here are the biggest signs that you can afford it:
- You don’t have any credit card debt.
- You have an emergency fund to cover any sudden expenses, ideally with at least three to six months’ worth of living expenses.
- You’re able to pay all your bills and save at least 20% of your income each month.
Assuming you can afford the loan, you should carefully evaluate the borrower and their request by asking yourself these questions:
- How close are you with them? If it’s someone you met recently or who isn’t a close friend/family member, you have to wonder why they’re asking you specifically for money and if it means they couldn’t find anyone else to do it.
- Have they asked you for money before? Repeated loan requests are a bad sign, as it usually means the borrower isn’t managing their money well. By helping them out all the time, you’re enabling them and making it more likely the pattern will continue.
- How much do they need to borrow? The more money they’re asking for, the more wary you should be. It’s more likely they’ll have trouble paying back for a larger amount, which means it’s more money you could potentially lose.
How to set up a loan to a family member or friend
So, you’ve decided to go through with the loan. To reduce your risk and increase your odds of this loan going smoothly, there are a couple ground rules to follow.
Don’t lend more than you’d be comfortable losing. No matter how well you know somebody, it’s not a guarantee that you’ll get your money back.
Set a firm payment date. A big problem with loans between friends is the lack of a payment timeline. They’re often open-ended, with the borrower promising to pay back the lender in a few weeks, or months, or sometime in June.
It’s imperative that you set a payment date so that there’s no confusion about when the borrower needs to pay you back.
In addition, you may also want to get the loan agreement in writing. This gives you something to reference if there’s any dispute about the terms of the loan, and it could help you if the borrower tries to avoid paying you back.
How to turn down a loan request
It’s also smart to have an idea of how you’ll decline a loan request, just in case you run into that type of situation.
The best way I’ve found to phrase this is by saying, "Sorry, I have a rule against lending people money."
Another popular choice is, "That’s not in my budget right now." Although this can work, it could also lead to an uncomfortable round of "Let’s Make a Deal" where the borrower keeps asking if you can lend them a smaller amount.
A tricky decision
It’s safe to say that loan requests between friends and family can be fraught with peril. To help head off problems before they start, you should:
- Verify that you can afford the loan.
- Carefully evaluate the borrower.
- Be aware of all the possible consequences, including losing your money.
- Set concrete loan terms with a payment due date.
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