It's a topic I have blogged about before, but it's an important one. A friend of mine was recently burned when a friend of his loaned some money for a business venture that failed and was unable to pay him back. As you can imagine the friendship has seriously soured. I wish he'd chatted to me before he'd generously loaned the money rather than afterward.
A number of years ago one of my clients came to me to ask my advice about loaning a significant amount of money to her daughter. The first question I asked was whether there was any chance that her daughter might not pay her back, to which she replied "oh there is every change she won't pay me back."
I knew her financial position and knew that she couldn't afford that risk so told her to explain to her daughter that she wasn't in a position to help out.
But there are cases where we are in a position to help and at the end of the day, the only person who can decide if you want to loan a friend or family member money is you, but I do have some tips.
Questions to ask yourself:
1. Will you suffer financially if the loan isn't repaid? If the answer is yes then my recommendation is to walk away. You don't want to put yourself into financial hardship because of somebody else's money problems.
2. Will your relationship be damaged beyond repair if the loan isn't repaid? If the answer is yes then, again, I recommend walking away. You don't want to lose your relationship AND your money. In the very few times I've loaned money, I have gone into the arrangement with the attitude that if I never saw the money again, I would live with it. If I can't feel that way then I just don't do it.
3. How formal do you want the arrangement to be? If someone asks to borrow money from you, particularly if it's what you consider to be a sizeable amount, then you have the right to expect a formalised written agreement. The written agreement should state the amount borrowed, any interest that may apply, payment terms (how much and how often), and the date the loan should be finalised.
I'd recommend having the agreement drawn up by a solicitor and I personally believe that the person borrowing the money should foot the cost of the fees.
4. Will you charge interest? And if so, at what rate? Often loans between friends or family members are no interest or low interest and this is of course up to you. You may wish to apply a market rate of interest, particularly if you believe there's a reasonable chance that you might not get your money back. Perhaps it's unlikely that person will be able to get a loan from a bank or other lending institution and would be more than happy to pay the market rate to obtain the capital.
You do need to be aware that legally you have to declare all interest to the ATO, even if it's a loan between friends or family.
5. If it's not a formal written agreement, what are your terms? Even if you decide not to formalise the agreement, I do think you need to be clear on the terms. Your terms might include a structured amount to be credited to your account each month or a lump sum to be paid at the end of a certain period.
6. And once you've decided the terms, what happens if the terms aren't met? At what point are you going to start jumping up and down or at least give a little nudge? That's probably something you should also agree upon from the start. And if the loan is never repaid - what are you going to do? If an agreement is in place, are you going to take legal action?
Probably the best advice I can offer is to be totally up-front right from the start. You may feel a little awkward, but if someone has had the courage to ask you for a loan, then setting the terms should definitely be your prerogative and should be expected. Some ideas for approaching this might include:
"This is a lot of money to me and while I'm happy to loan it to you, I will need it to be repaid in monthly instalments by July. Is that going to work for you?"
"I won't need the money for the next twelve months, but after that I really do have plans for it. Will you be able to pay me back by September next year? And will you do that as a lump sum or regular payments?"
"I'm happy to loan you some money, but I have to be honest, I've seen some relationships turn really sour when money is involved and I would hate that to happen to us. Would you be agreeable to formalising the arrangement so that we don't have to worry about any of that?"
"If you happen to miss a payment, do you want me to give you a reminder straight away or give you a few days in case it's just slipped your mind?"
At the end of the day it comes down to personal circumstances and your relationship with the person needing a loan. Just make sure you consider the risks involved and what you need from the arrangement.
If you'd like to hear more of what I have to say on the matter, click here for a recording of my most recent "You & Your Money" radio segment on 98.1FM Radio Eastern.