Has a friend or family member reached out to you for a loan? The lending environment has gotten very strict since the 2008 economic crisis, so more people are turning to friends and relatives to borrow money. According to the National Association of Realtors, last year 6% of first-time home buyers received a loan from a friend or relative so they could make a home purchase. Furthermore, the National Small Business Administration reports friends and family lent money to help 18% of small business owners meet capital needs.
You might be tempted to write a check so you can help a loved one who has fallen on hard times, wants to make a home purchase, or fund a business. However, things can get sticky if you don’t handle the situation properly. Here are five tips for navigating this situation.
1. Don’t do it
If you want to steer clear of the possibility of a broken or strained relationship because of an unpaid debt, you may want to turn down the request. However, if you really feel the need to help, you’ll have to set some ground rules so that no one is taken advantage of. Start by using online services such as LendingKarma and Prosper, which help borrowers and individual lenders keep track of payments.
2. Figure out whether you can afford to help
Don’t lend money if it will leave you in a financial bind. Take care of your own household first. It doesn’t make sense to lend a hand if that means you’ll have difficulty paying your bills and making ends meet. Assess your finances and only lend if you can comfortably afford to do without that money.
3. Draft an agreement
It will be important to have a written agreement outlining the loan terms. Make sure to include the loan amount, how and when the loan should be repaid, and how much interest will be charged (if you decide to do so). It would also be in your best interest to obtain signatures and have the document notarized so that you officially document the loan.
4. Charge interest
Charging interest is a good idea because the Internal Revenue Service will consider the loan a gift if you decide to waive interest. Furthermore, gifts of more than $14,000 will be taxed. If you would like to avoid the loan being treated as a gift, the IRS requires charging at least the Applicable Federal Rate, which is updated each month. Know that it is not mandatory for you to charge interest if the loan is less than $10,000. You also don’t have to charge interest for loans up to $100,000 in cases where the recipient’s investment income for the year is below $1,000. Also know that payments for tuition and medical expenses are not considered gifts.
5. Prepare for the possibility you’ll never see your money
When you lend money to friends and family they often expect you to be more lenient just because they know you well. A study by the Journal of Economic Psychology titled “Lender’s Blind Trust and Borrowers’ Blind Spots” found that borrowers have a tendency to treat loans as gifts. You will have to be comfortable with the fact that you may never get your money back. That’s why it’s important to make sure you can afford to lend. If not, your kindness will hurt you in the long run. If gentle reminders haven’t worked and you really need your money, you may have to take your loved one to court.