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There’s always a risk in lending money, but lending money to friends or family is particularly fraught with danger for both the lender and the borrower. So how do you minimize the risk of saying yes?
If your first inclination is to agree to lend the money, take a step back and ask yourself these questions:
- Are you likely to get the money back, and can you afford to make the loan if you’re never repaid? If the money takes a significant chunk out of your own emergency fund, you probably shouldn’t take the risk.
- Why does the prospective borrower need the money? There’s a big difference between lending money to your sister who wants to add space to her successful restaurant, and lending money to your brother with the drinking problem who just quit his third job in five years.
If you’re still comfortable with the idea of lending the money, take the following steps to protect yourself, the borrower and your relationship:
- If you’re lending money to a family member, be discreet. First of all, your youngest daughter’s financial troubles are no one else’s business unless she wants to tell them herself. Secondly, other family members might be slighted or worry that their portion of the estate has been diminished.
- Reach an agreement on the amount of the loan, the interest rate and the repayment schedule, and then put it in writing. Notarize the agreement.
Taking these steps will relieve some of the potential discomfort in the relationship and increase the likelihood of repayment. The terms can be renegotiated further down the road, if you want, but make sure the new deal is handled in the same manner as the original.
It might feel a little odd to charge interest to people close to you. After all, why should you benefit financially from doing a favor for close friends or relatives? There are several reasons to charge interest, not the least of which is averting potential taxes.
- You’re almost certainly gaining some interest on the money you’re lending, and doing the favor shouldn’t cost you money.
- Lending money without interest makes the loan look more like a gift to the IRS, and there are limits to how much money you give before you have to begin paying taxes on it. Right now the cap is set at $12,000 per person, per year.
- The IRS actually demands that you charge interest and calculates a minimum interest rate that changes monthly. You can find the applicable federal rate (AFR) on the agency’s website.
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