Q: My long-time friend from college came to see me last week and told me that she needed to borrow some cash. She promised to pay me as soon as possible. I wanted to help her but I don’t know if I should lend her money. What is the best way to handle this? – Raiza by email
It is not easy to lend money to friends and family when your hard-earned savings is at stake. The decision to lend becomes difficult because you are struggling between helping your loved ones and making a sound financial decision.
Lending money to friends and relatives puts your relationship at risk. Will you treat your friend the same way as before if later on she could not pay back the money she owes you? When someone you care is in need and you have the money to help, should you refuse? How do you balance the risks of disappointing your loved ones and of losing your money?
Most of the time when you are confronted with this kind of situation, because of friendship and familial relationship, your emotions can easily sway you into handing over your cash without risk considerations. Here are the five mistakes that everyone should avoid when deciding to lend money to friends and family:
1. Not asking how the money will be spent and repaid
When you lend money, there is always the risk that you will never get your money back. It is important that you understand how your friend plans to use your money and how she can repay you. By understanding the plan, you will appreciate how much risk you are taking.
There is a higher chance that you will not be paid soon if the loan is for consumption rather than investment. For example, if the intention of the loan is to pay off your friend’s credit card debts or household obligations like rental and utilities, you need to find out if your friend has the financial capacity to pay you. The fact that your friend could not pay her expenses means the risk is higher that the loan can be problematic later on.
If, on the other hand, your loan is used for investment, for example, to finance extra inventory for the holidays, you will have a better chance of getting paid because the inventory can be easily converted to cash upon sale.
Do not hesitate to ask how your money will be used by your borrower. When you know your risks, you can make better decisions on how to allocate your savings to help your friend.
2. Not charging interest rate to compensate for risks
The money that you loan out is the money that you could have invested. The income from investment that you could have earned is what we call the opportunity cost. If you don’t want to lose the extra income from possible investment of your funds, you can collect this from your borrower in the form of interest rate.
Aside from the opportunity costs, there is also the risk of default or not getting paid in full. You can compensate this risk by raising your interest rate. The higher the risk you perceive, the higher the interest rate should be.
Knowing how risks can be incorporated into interest rate can help you determine how to charge more or less fair rate if you are loaning to your friend or a relative. For example, if you think the interest rate you should ask is 12 percent after considering all the risks, you can use that as basis for offering discounts because the borrower is a friend in need.
3. Not considering how much money you can afford to lose
When you lend money to a friend or relative, there is always the risk that you will have problem collecting later on. Either you may only be paid partially or you may not be paid at all. When that happens, your relationship will always be at risk.
Before you decide to help your friend, consider how much money you are willing to lose. Do not lend the money that you will need for your retirement, or for a major capital spending like house renovation or family travel that you have been saving for some time. Allocate only the excess money that you are willing to lose if things don’t turn out as expected.
While you can you consider it as a loan to your friend, you can internally consider the amount as a personal help so you can manage your expectations.
4. Not documenting the terms of the loan in writing
If you decide to lend money to a friend or a relative, make sure to document all the mutually agreed-upon terms in writing. The loan document will be your reference in the future in case some disagreement arises as to the terms and interest.
Having a documented loan agreement will also serve as your protection. You can also indicate the actions that you intend to take should your borrower default on or miss any payment.
When you make the loan agreement, you and your borrower must mutually agree on the terms and conditions. The agreement will state when you need to get the money back. What happens if the borrower can’t pay you on due date? Documenting the terms between parties will make the process less stressful down the road.
5. Not saying NO when you don’t want to lend
There are times when you can’t afford to lend your friend or relative because you don’t have extra cash to spare or you simply don’t want to risk any amount at all. When you are faced with this situation and you are struggling how to turn down your friend’s request for a loan, simply respond by saying that it is your personal policy not to lend to friends or family members.
Saying no doesn’t mean you don’t want to help. If the loan request is business-related, maybe you can help by referring some clients or suppliers who can provide some friendly credit terms. If the request is personal like someone in the family needs medical assistance, you can help by giving a cash contribution.
Henry Ong, RFP, is president of Business Sense Financial Advisors. Email Henry for business advice firstname.lastname@example.org or follow him on Twitter @henryong888