“To thine ownself be true,” may be some of the most repeated advice from Shakespeare’s Hamlet, but we also should not forget this advice from Lord Polonius:
Neither a borrower nor a lender be;
For loan oft loses both itself and friend…
In reality, most of us are fairly generous people, and we want to help a family member or friend with a loan when we can. The other reality is that a person who can’t borrow money from a traditional source (especially in today’s easy credit environment) often has damaged credit or no credit, both of which make such a borrower a greater credit risk.
For the record, I believe that lending money to friends and family is far preferable to cosigning a loan for someone who can’t qualify on his or her own. CoSigning creates a false sense of security. You think the primary borrower is responsible for the loan, and that you as a cosigner are not. In fact, when you cosign, you are on the hook for the entire loan. Even if it is paid on time, your credit score will be affected by the loan if it is reported to the credit bureaus.
Warnings aside, there are times when you may be asked to loan money to someone you know for any number of reasons. These can include:
- Capital to start or grow a small business;
- A down payment or loan so your child or relative can purchase a home;
- Money to help someone get back on his or her feet after a divorce, illness, or other catastrophe;
- Helping a younger person or immigrant establishing credit for the first time.
If you are going to lend money to someone you know, you might as well increase your chances for success. Here’s how:
1. Set a Fair Interest Rate
This can work in your favor, as well as the borrower’s. The interest rate you charge can still be competitive with the rate your borrower can get from a traditional lender, but high enough that you make more money than you would if you parked your money in a safer bank account. If your borrower balks at being charged interest, you might want to blame it on the IRS. That’s because if you give person more than $12,000 in a year, it will likely be treated as a gift and subject to gift tax. To avoid this potential complication on a larger loan, you must charge an interest rate that is at least as high as the IRS’ Applicable Federal Rate, which is set monthly.
2. Get Your Agreement in Writing
If you think it is “uncomfortable” to insist on a written loan agreement, think about how uncomfortable you will be trying to collect if your borrower falls behind. If you have to, blame it on your spouse, accountant, or someone else who “insists you get it in writing.” You can find a sample promissory note online or in a legal forms book, or if the amount is large enough, you can ask an attorney to draft it for you. Spell out the terms, including how much is being borrowed, the interest rate, late payments and when they will be assessed, and how/where payments will be made.
3. Set up a Formal Payment Arrangement
Let’s face it: it will be easier for your borrower to make a late payment to you than to his or her other creditors. And I doubt you want to become a debt collector. So include in your agreement the details of when payments are due, late fees that will be charged, and how you want payments to be made (by check or PayPal, for example). I don’t recommend you accept cash. I do recommend that you set up a copy of any checks or money orders in a file in case there is a disagreement about payments that were made later. Go a step further to arrange automatic deductions from the borrower’s bank account to yours, and you won’t have to worry about whether the check is in the mail.
To learn more about how loans work and about best-practices for lending, read more from our experts by visiting our Loans Learning Center.