Most of us are fairly generous people, and we want to help a family member or friend when we can. But the fact is, a person who can’t get a personal loan from a traditional source often has damaged credit or no credit, both of which make this borrower a greater credit risk. (There are also loans for bad credit, but perhaps this person has yet to apply for one.)
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 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 a personal loan, for example, you are on the hook for the whole cost. Even if it’s paid on time, your credit score will be affected by the loan if it’s reported to the credit bureaus.
All 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
If you’re going to lend money to someone you know, you might as well increase your chances of success. Before we get into that, let’s make one thing clear: Your friends and family do have some options.
Can You Get a Personal Loan With Bad Credit?
If they’re in need of extra funds, but their credit isn’t in great shape, they can try to apply for personal loans for bad credit. The process will entail gathering personal information, including their credit score, as well as proof they can pay the loan back. After spending some time researching minimum credit score requirements for personal loans from lenders in their area, they may feel confident enough to apply for a loan. (Note: if they have a good relationship with their bank or credit union, they may want to start their search there.)
Of course, these personal loans will likely carry higher interest rates, so your loved one may want to try brushing up their credit before applying. To get started, they can view their free credit report snapshot on Credit.com. The snapshot provides a free credit score, along with notes on what they can do to improve their scores. However, in general, you can raise a credit score by paying down high credit card balances, disputing credit reports errors and using a starter line of credit, like a secured credit card or credit-builder loan, to establish solid payment history. Even if you have bad credit, check out sites like PersonalLoans.com, BadCreditLoans.com and Avant.com as they offer loans to people with bad credit, and are known for having high acceptance rate loans.
If directing your friends and family to a personal loan is out of the question, read on.
Lend Money the Smart Way
- 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 Internal Revenue Service. That’s because if you give someone more than $12,000 in a year, it’ll 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’s at least as high as the IRS’s Applicable Federal Rate, which is set monthly.
- Get Your Agreement in Writing
When you loan money to friends and family, it’s best to get your agreement in writing. If you think it’s “uncomfortable” to insist on a written loan agreement, think of how uncomfortable you will be trying to collect if your borrower falls behind. Another option is to blame 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 and where payments will be made.
- Set up a Formal Payment Arrangement
Let’s face it: It’ll be easier for your borrower to make a late payment to you than to other creditors. I doubt you want to become a debt collector, so include in your agreement the details of when payments are due, how late fees that will be charged and how you want payments to be made (by check or PayPal, for example). I don’t recommend taking cash, as it’s harder to track. I do recommend that you keep a copy of any checks or money orders in a file, in case there’s a disagreement about payments that were made late. Go a step further to arrange automatic deductions from the borrower’s bank account to yours, and you won’t have to worry if the check is in the mail.
Lending money to a friend or family member with damaged credit can be risky, but your generosity and support can be crucial. By taking the right precautions, you can avoid any hurt feelings or bank accounts since you’ll set both yourself and the borrower up for success. Lay out all of the expectations and have everything in writing to keep things clear. Loaning money will be much simpler and less stressful when these tips are put into action.
To learn more about how loans work and best-practices for lending, read more from our experts by visiting our Loans Learning Center.
This article has been updated and was originally published November 23, 2016.