Relationships between people are always complex even if they care for each other very much. If money gets involved, things will surely become even more difficult. When a friend or a family member comes to you with a request to lend him or her money, it is perfectly natural to feel a bit uneasy.
On one hand, you really want to be of help as you are truly loyal to this person. On the other, you are wondering if and when you will get your money back and whether you can actually afford to be of aid. Here you will get information and tips to help you make the right decision depending on the particular situation which you are in.
How to View Such a Loan?
You don’t have to be a specialist in studying human behavior to know that even your beloved aunt or your best friend won’t ask for a money gift outright. They will use the word “loan” for sure. Indeed, if you have ever had to ask someone to give you money, you would have specified that it would be “on loan”. This does not necessarily mean that the person who is asking you for financial assistance won’t or doesn’t intend to pay you back. However, you need to realize that the repayment is far from certain.
Just ask yourself why someone would ask a relative or a friend for money when all types of credit products from credit cards to consumer and car loans are readily available. They most probably don’t qualify because they are currently in great debt and/or have bad credit history. Of course, it is possible for the situation to be an emergency. If the person who needs the money urgently doesn’t have savings, such a request will be perfectly logical. As you can see, in all of these cases, the person who is asking loved ones for a loan will have hard time paying the money back.
Given all this, the best thing to do is to treat the loan to a friend or a relative as a gift not formally, but in your mind. This will make it a lot easier for you to decide whether to grant this loan or not. If you do, you will not have to suffer disappointment and ruin your relationship with the borrower in case he or she doesn’t pay you back. Of course, it makes perfect sense to ask the person about the intended repayment time and method. Just ask the borrower how he or she plans to repay you given his/her income and spending.
Consider Your Finances
Once you have a clear idea of how to view the loan to a friend or relative, you have to figure out whether you will be able to afford providing it. Do the math to see if the loan amount will fit into your monthly budget. If you have to reduce your savings installment, check exactly how much the reduction will be to ensure that it won’t hurt your savings plans and goals. If you will have to dip into your savings to provide the loan, you have to calculate whether and by how much you will have to decrease your spending and/or investment in the future. The more detailed your calculations and analysis are the better.
If the impact of the loan on your finances will be minimal, then you can feel comfortable about giving it to the respective friend or family member. However, if your calculations and analysis show that you may struggle at one point or the lending will have great impact on your financial plans and goals, then the wise thing to do would be to say no. The key thing is not to feel guilty about the decision which you have made. If you cannot afford to help, this doesn’t make you a bad person, friend or relative. Perhaps you can help the person in trouble in some other way. You can provide support with budgeting and credit score improvement, for example.
If you plan to lend the person the requested amount of money without charging interest, the interest amount may be regarded as a gift for tax purposes. This means that you will have to pay tax on money which you will never actually receive. In the USA, the interest amount is calculated based on the Applicable Federal Rate, which is published every month. If it exceeds a certain limit, which is set every year, tax will be charged.
In this situation, the best thing to do is to charge this interest rate. It is extremely low so it will most certainly not make the loan unaffordable to the borrower. Just remember to explain the situation to the person to avoid misunderstanding and frustration. After all, charging interest will be the fair thing to do given the circumstances.
Signing a Contract
Whether you need/want to charge interest or go without it, it is best to sign a loan agreement with the borrower. This will increase your chances of getting your money back. Besides, it is wise to treat all dealings with your money as financial transactions. This will make budgeting and planning easier and more effective too.
You can readily find friend and family loan agreement samples on the web plus guides and tools on how to draft one yourself. You can also consult your attorney, if you deem fit. It is important to note that in order for this kind of agreement to have legal power, it does not have to be verified by a notary. It just has to be signed by both parties involved.
If you want to increase the chances of loan repayment, you can include a repayment plan within the agreement or as an attachment. Here is a simple example. If you lend the person $1,000 for 1 year and the annual interest rate which you charge is 0.8%, you can have him/her repay the loan in 12 equal installments of $90 which include both part of the principal ($1,000) and part of the total interest amount ($80).
How about Collateral?
Banks would normally ask for collateral (security) when the loan amount is high. You are certainly well familiar with the most widely used secured loans – car loans and home loans. If you plan to lend a friend or a relative a large amount of money, you may consider making the loan secure and asking for collateral. If the person cannot repay the loan in line with the specified terms and conditions, you will have the legal right to take over the asset placed as collateral. Even if the borrower agrees to this kind of deal, however, there are many legal requirements which have to be met. You must consult a specialized attorney to find out whether and how the loan agreement including collateral can work out in your state.
Keep in mind that you are the one who has to make the final decision of whether to give a loan to a friend or relative in need. Go through the steps suggested here to make the best choice in your particular situation. If you decide to lend the money, make sure that you put the terms and conditions in a written agreement.