Helping Family Members

Invariably, at some point, a family member will ask you for financial help. This might be a sibling asking you to co-sign for car loan…a child asking for help buying a first house…or a parent desperate to get out of a bad debt.

The consensus opinion—with regard to protecting your own credit—on helping family members: Lend cash, if you can. Even consider borrowing on your own in order to lend. But don’t co-sign.

This advice runs against what’s usually the easiest thing to do. Credit card companies, auto finance companies and mortgagers all make it easy for family members to co-sign on loans. But co-signing makes the co-signer fully liable for the debts. This is the a serious risk to your credit.

The challenge to making a good personal loan is balancing the personal and financial interests. No matter what a contract says, the ultimate security for most personal loans is your friendship with or family ties to the borrower. You count on these ties to compel the borrower to make the interest payments and return the principal.

A good approach is to ask the friend or family borrower questions that give some terms to the transaction—and give you information on which to base your decision. These questions should include:

• How much do you want to borrow?
• How long do you want to borrow the money?
• What—exactly—are you going to do with the money?
• How do you plan to repay the loan?
• Do you have a backup plan, in case your first plan doesn’t work?
• Are there any benchmarks or guidelines that will measure your ability to repay while you have the loan?
• Do you have any collateral to secure the loan?
• What other lenders have you approached?
• If this loan doesn’t perform as we plan, how will you react when we see each other socially?

The answers to each of these questions tell something about the borrower and the loan.

The main relevance of the how much question is how realistic the borrower is about his or her needs. Does your cousin the school teacher need $10,000 to add to the $20,000 in cash she’s saved to put down on a house? That’s a rational request. Does she want to borrow $150,000 to move into a swanky neighborhood? She may be confused about money and earning power.

There are no simple guidelines for determining how much money you should loan someone. From a risk management perspective, it’s not a good idea to concentrate more than 10 percent of your assets in any single investment. And a loan…even a personal loan…is an investment. But, in cases of family businesses or some real estate investments, it might make sense to make a larger loan.

The how long and how much interest questions give you some idea about how grounded the borrower is in reality. You don’t want to hear things like “I don’t know” or “Well, as long as I can keep it.” These suggest that the borrower isn’t treating the cost of the loan seriously—which suggests he’s not thinking seriously about repaying it.

Like any financing, a personal loan should charge less interest as its term gets shorter. You might loan a family member money for a few weeks interest-free; but a 10-year loan needs to pay interest.

The what are you going to do question and the how will you repay questions should give you some insight into the borrower’s mind set. You don’t want to hear a tearful admission of drug addiction, adultery or looming bankruptcy. Personal crises can mean that you’re throwing good money after bad.

Keep in mind, if a friend or family member is asking you—instead of a bank—for a loan, there’s probably some kind of problem afoot.

More broadly, you can usually organize needs into two rough categories:

• rectifying trouble situations, and
• pursuing opportunities.

Loans made to rectify trouble are more likely to cause problems. The borrower may simply be swapping existing troubles for…troubles with you.

Crafty or desperate borrowers will sometimes describe a rectify-trouble loan as a pursue-opportunity loan. That’s why you should ask a lot of detailed questions about any use of the money. Look for any hazy lack of detail.

A business/personal use distinction may also be useful to know. Many lenders believe that in family money situations, the more business-related the loan, the more likely you’ll get your money back in a timely manner.

If the borrower has been thinking about using the loan to start a business, he or she should have already worked out the benchmarks of performance that will measure ability to repay. If the benchmarks aren’t there, the plan may not be that strong.

With a business, the need may be genuine. Banks and other commercial finance sources provide capital for business. But new businesses—and small businesses, even when they aren’t new—usually have a tough time tapping into this source of money, so owners approach their family members.

Next: The Promissory Note