When a friend or family member comes to you in dire financial straits and asks for a loan, it can be difficult.
Being asked to lend money to friends and family can put you in a tough position, because of how hard it can be to say no to someone you’re close to.
Still, while it may feel like the right thing to do, loaning to friends and family members can be a risky proposition — and it can create strains in relationships.
While you can loan money to friends and family, the question is, should you?
There are a couple of questions you should consider when you’re trying to decide what to do.
Can You Afford It?
Your initial impulse when someone that you’re close to asks to borrow money is probably to be compassionate and grant the request.
But before you agree to lending money, you should consider if it’s something you can actually afford.
It’s not fun, but play out the worst case scenario: your friend or family member doesn’t pay you back.
Is the amount that you’re lending an amount that you could afford to lose? Or would this loan, if unpaid, put you in a financially risky situation?
Everyone wants to help the people they’re close to, but you shouldn’t deplete your finances to do it.
Will the Person Pay You Back?
This is a harsh truth, but if you feel financially secure enough to give out a friend or family loan, you’re going to have to do your own personal analysis of whether or not you think they’re going to be reliable and pay you back.
In this scenario, you have to think like a professional banker would. Essentially, you have to assess the situation and decide if making this loan is a smart move.
That doesn’t mean you have to be cold and calculated, but it does mean you have to make your decision with an awareness of payback likelihood and how that might affect your relationship with that person.
Do You Know the Rules?
While giving out a loan to a friend or family member may seem like a straightforward and private affair, there are rules even to informal loans, and the IRS may get involved.
Generally, you’re going to use a loan agreement contract template to establish a promise to you from the lendee that the loan will be repaid, which is also known as a promissory note.
If you are lending this money at zero or below market interest rates, you may have to pay interest on income not earned because you are lending below the usual requirement.
It might be a difficult conversation, but it’s smart to set up a solid repayment schedule and charge an agreed-upon interest rate. This will make the loan legitimate to the IRS and will avoid potential costs for you down the road.
Are There Other Ways to Help?
If you want to help your friend or family member but are shaky on the concept of lending them the money, there are other routes that you can take.
Under IRS law, you can outright gift someone amounts of money under $15,000 dollars without incurring a tax charge.
You can also become a co-signer on a personal loan for the friend or family member to help them get a line to funds they otherwise wouldn’t be able to access, although this can have its own risks.
For instance, if the borrower defaults on the loan, you will be on the hook for repayment, and if the borrower is late on payments, it will affect both their credit score and yours.
So, What’s the Verdict?
There’s not a simple yes or no answer when it comes to lending money to friends and family, but there are measures you can take so that if you decide to lend, you’re doing so in a way that won’t put you in financial jeopardy.
You should consider the likelihood that it will get paid back, draft up a loan agreement, and you can even discuss co-signing on a personal loan instead.
Having a giving attitude toward those close to you is an admirable trait, but so is protecting yourself when it comes to risky financial situations.
Wondering how to save in case you find yourself in a financial emergency of your own? Read our beginner’s guide on starting an emergency fund.