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You’ve heard it before. Lending money to a relative is like giving it to them.
But I’m here to tell you that personal loans between friends and family can work – if you do it right.
To figure out how to make them work, we need to first see why these types of loans go wrong in the first place.
Is it because your friend is forgetful? Is it because your cousin is too cheap? No. It’s because they convinced themselves it was actually a gift and not a loan.
So can you make personal loans between friends or family work?
Yes, here is how.
Ask what the money is going to be used for
Always ask where the money is going before you decide whether or not to make the loan. Make sure it’s being spent on something worthwhile.
How would you feel if the other party used the money to have a nice vacation at your expense? What if it was to make an investment?
If you’re going to get involved and offer a loan, make sure it’s for something urgent and important.
If the other party gets offended by your question, that’s a good sign that you shouldn’t be making the loan in the first place.
It’s important that both parties talk about money openly and honestly first.
Discuss the terms of your loan up front
Talking about finances with friends and family is never easy, but if you’re in the position to lend money, you really need to talk about all of the terms.
This includes interest, repayment schedules and late fees.
It is so important to discuss the details beforehand so there will be no misunderstandings later on.
I mean, you could be expecting to be paid back all the money a little bonus as a thank you. But if you didn’t talk about it, forget about it.
You could be expecting to be paid back within a month, but if it wasn’t discussed, you could instead see your money next year, if ever.
And what if they’re late? Do you get a late fee or nothing at all? If you don’t discuss it, the only thing you’ll be getting is into an argument!
Get it in writing or don’t do it at all
The key to making loans to friends and family work is to get your loan terms in writing.
Verbal contracts mean absolutely nothing. There will always be disagreements and misunderstandings.
By having your agreement on paper, your friend/relative will feel an obligation to pay it back.
There will be no mistaking that this is a loan and not a gift. It’s right there in black and white.
Your agreement doesn’t need to be written up by a lawyer. It doesn’t even need to be typed!
It doesn’t matter if it won’t hold up in court (it will). The purpose of this note is to make this financial transaction an official loan in their eyes.
If you feel uncomfortable having your relative sign something, then don’t loan them money in the first place.
If they are the ones who don’t want to sign it, then apologize for trying to help them out.
Charge them interest
If you offer your relative an interest-free loan, they will not feel obligated to pay it back. An interest-free loan is such a gift to them that it makes the loan appear like a gift.
If you are offering them a loan, it needs to come with interest.
ALL loans charge interest.
Give them an amazing deal though since they’re family. If a bank will loan them money at 15%, give them a 5% deal.
Without charging interest, there’s this “you owe me one” mentality from the lender (you). With interest, it is a fair transaction both people are happy with.
Set monthly payments with due dates
Make an agreement with your friend or relative to pay back the loan in payments every single month.
Don’t just say “pay whatever you can, whenever you can”. If you do that, you might as well kiss your money (and your friendship) goodbye.
You need to make it clear (in writing) how much money they are paying you back, for how long they are paying you back for, the exact date of the payment due each month and late fees.
Agree on (and charge) late fees
Yeah I said late fees.
If your loan doesn’t have a penalty for being late, expect your friend to pay you late every month, if at all. Each month they will get progressively more tardy until they eventually stop paying you back altogether.
Make sure you specify their due date and what penalty will be incurred if they are late.
But again, this needs to be agreed upon up front.
Get collateral on a large loan
If you’re letting someone borrow a few bucks, you can let this one slide.
But if you are making a sizable loan (something north of $5,000), you need to get collateral.
Personal loans carry a very large interest rate because there is typically no collateral.?
When you get a car loan or a home loan, interest rates are low because if you don’t pay the bank takes your car or house away.
For a person-to-person loan the risk is all on you, the lender.
Heck, you can’t even mess up their credit score if they fail to pay you back.
The collateral could be the title of their car, jewelry or some valuable collectible they own.
You will need to take possession of the item first before you hand out the loan, then give it back after the final payment.
Distance yourself from the loan
Once the loan is made, resist the urge to micromanage how the money is spent.
While you may feel an attachment to the money, it’s not yours anymore.
Once the transaction is done, the money is no longer yours and deciding how it is spent isn’t up to you anymore.
Don’t like how that sounds? Don’t let someone borrow money in the first place.
Don’t co-sign a loan
If you want to lend a friend money, go ahead and do it. I won’t stop you. But do not lend them your credit score.
That is exactly what you will be doing when you co-sign a loan.
Cosigning a loan is a huge problem just waiting to happen.
The problem with cosigning a loan is that their late payments can result in your credit being ruined.
Think about why they’re asking to use your credit in the first place. It’s probably because they have bad credit, which means they don’t pay their bills. See where I’m going with this?
The last thing you want is an irresponsible person in charge of your credit score.
What do you do if you get stiffed on the loan?
Loans to family and friends go bad all the time. I mean, why are they asking for money in the first place? Because they need it and don’t have it.
And many times, they have zero plan for how they are going to pay you back. They’re just focused on solving their most immediate problem first: getting the funds.
So invariably the time comes to pay back the loan and they’re still flat broke.
You have two choices here.
- Throw a tantrum and end the relationship.
- Keep the relationship but never let them borrow money again.
Depending on the circumstances (how legitimate their excuse is), it may be best to just take it on the chin and take it as a lesson learned.
Only lend what you can afford to lose
This last tip is my favorite one. When it comes to offering a loan, only let someone borrow an amount you can comfortably afford to lose.
Assume you won’t be paid back. Assume this is a gift.
- The best case scenario? You get paid back all your money plus interest.
- The worst case scenario? You lost your money, but your overall financial situation remained unchanged.
Have you ever loaned money to friends or relatives? Why or why not? Let me know in the comments!