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Lending to Friends and Family Is It a Good Idea

by Jim ONeil on May 28, 2011

in Personal Finance Tips

There is an American proverb that reads, “Before borrowing money from a friend, decide which you need most.” The general advice we receive regarding lending money to friends is not to do it. While some of us have responsible friends who will repay the money in a timely manner, others of us may find ourselves in a nursing home before repayment is made, if we are lucky.

Deciding whether to lend money to a friend can be difficult, especially if you are unsure whether the person can afford to repay the funds.

Anyone who finds himself or herself being a potential lender to a friend should consider several things. Perhaps the most important is whether the would-be lender can do without the money. This involves considering much more than whether the funds are sitting in the bank account.

It is likely that the money will not be repaid for months. If an emergency arises in the meantime, the lender should have a plan for dealing with this unexpected expense. If he or she would need to borrow money in this event, then lending to a friend is not recommended.

Individuals who are chipping away at financial burdens like paying off a car loan or debts should think about how much this lending will set them back. Those who are saving money for a large purchase like a boat or house should also consider the impact of lending to a friend.

It is sometimes difficult to justify putting off our own goals simply because a friend needs help. While it is admirable to be martyr-like for others, this only goes so far for most of us.

Aside from considering whether lending the money is affordable, it must be considered whether the friend can afford to repay the loan. A related issue is whether the relationship is characterized by enough trust that repayments will be made willingly, without needing to be chased down and cornered to shake the dollars loose.

When considering this, things like whether the friend is working, how much the person makes, and the amount of other financial commitments should be discovered.

If the person does not earn much money and is struggling to get by, a loan may not make a big improvement in the financial situation. It may just cause the lender to lose the money and a friend at the same time. Finding out whether anyone lent money to this person in the past and whether it was willingly repaid will shed more light on the situation.

An overall understanding should be gained regarding how effectively this person manages money. As the picture begins to develop, the lender will see whether he or she should proceed with caution.

The reason the person needs the money may also influence the decision. Someone may be more willing to lend cash for a new heating system than a five-star vacation. If the friend is not forthcoming about the reason, it may be best to ask if the money can be paid directly to the source or to entirely avoid the situation.

If things seem legitimate, there is then the consideration of whether to charge interest and if yes, how much. There is nothing inappropriate about charging a friend interest because the lender should not be the one to pay for the privilege of borrowing.

Once the decision is made to proceed with the loan, issues like interest rate and collateral should be decided. An appropriate amount of interest would be whatever the money was earning in the savings account. Collateral may not be necessary unless the lender questions the financial background of the friend.

Nearly anything can serve as collateral but it is usually worth as much as the amount of money lent.

Though we never think our friends would renege on a loan, it can happen. Therefore, we should protect our investment and ourselves. Terms should be agreed upon up front including how much will be lent, interest rate, term, and monthly repayment.

If collateral is involved, an agreement should be made regarding what will be held and when it can be sold to recoup the money following failed adherence to the repayment terms.

All loan and collateral terms should be put in writing on an agreement that both the lender and borrower sign in front of unbiased witnesses. If a great deal of money is being lent, a solicitor can help with this step. The Citizen’s Advice Bureau is another entity that may be able to provide assistance.

Once the agreement is signed by both parties and witnessed, the borrower should receive a copy and the lender should hold the original in a safe place.

The money can then be transferred. It is recommended to do this via bank transfer or check. This creates a record of payment that can be confirmed. If a bill or debt is cleared directly on behalf of the borrower, the lender should request a confirmation of payment.

Once the money is transferred, the borrower should establish a standing order to the lender’s bank account for the monthly repayment amount. The lender should request confirmation from the building society or bank that this has occurred.

Repayments should be recorded in writing by the lender to serve as a record and prevent disagreements regarding what has been paid and what remains to be paid. If the terms of the agreement change, the written contact should be revised and resigned in front of objective witnesses.

For example, the loan term may need to be extended if the friend is having difficulty making repayments as initially agreed.

Things can go wrong and if they do, resolution may require using the legal system. For loans under £5,000, a case may be filed in small claims court. Loans of a greater amount will require a visit to legal counsel to find out how to recoup the money.

Hopefully, things will never get to this point but if they do, a lesson about lending to friends will be learned.

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