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Personal Finance FAQ

Should You Ever Loan Money to Friends and Family?

Red ATM
This is where you should draw money from.

Friendship and money: oil and water.
–Mario Puzo

All of us know deep down inside that money is a touchy subject when it comes to friends and family, particularly when one owes money to the other. Yet, when we feel like times are tough, we turn first to friends and family to lend us the money to tide us over until we can turn them around. Or, alternatively, someone has come to us looking to borrow money to get out of a pinch. Almost invariably, despite the best intentions of both sides, the loan winds up being a sticking spot between the parties involved, and oftentimes, the end result is nasty.

A recent study by Carnegie Mellon University documented the trials and tribulations of borrowing amongst friends and family. Unsurprisingly, the results were not positive. Borrowers tended to overestimate their ability to pay and mentally recharacterized loans as gifts rather than loans. When they were delinquent, borrowers avoided the lenders, but didn’t think that the lenders were upset by the delinquent behavior.

Yet, despite that inner voice which screams “NOOOOOO!!!!!!!” at the thought of lending money to friends and family, we do it anyway. Why?

  • Nobody wants to be perceived as the “bad guy” in a close relationship. You want to enable your friends and family to succeed, so you think that saying “no” is going to harm the relationship.
  • We think that we could borrow from them if the tables were turned. Because we mentally place ourselves in the opposite situation and imagine what the other side would do, we immediately place ourselves in a position of feeling like we should return the favor. Humans are very impacted by the need for reciprocity – scratch my back and I’ll scratch yours. In this case, we’re imagining the need for reciprocity and allowing our Monkey Brains to tell us that we need to return the favor.
  • We think that we’re truly helping out the other person by loaning the money. Because they are friends and family, we think that we know them, that they’re generally responsible, and that this must be an exception rather than the rule. We don’t imagine that we’re giving the addict another drink.

There are better ways to think about the dicey situation when money, friends, and family don’t mix.

  • Give the money as a gift. That way, there are no expectations about whether or not the recipient is going to pay the money back. It allows the recipient to feel like he or she can remain close to the giver and not have to answer uncomfortable questions about when the money will go the other way. However, if you do this, then truly mean it. Once the check is written or the cash handed over, it’s out of your life forever.
  • Tie the gift to a change in behavior. Something has happened which requires the money, and that’s the root of the problem. Is it budgeting? Is it needing to get a second (or first) job? Whatever it is, the money doesn’t get paid until steps to change the behavior take place.
  • If it’s a loan, document the terms and conditions. If it’s a small loan, then you probably only need a written statement of interest, repayment terms, amount, and parties signed by both parties, but if it’s going to be a significant amount of money, then you probably want to get something more formal drawn up and recorded somewhere, to include repercussions if the loan is not repaid.
  • Don’t forget about taxes. There may be tax implications to this exchange, either gift taxes or imputed income, so make sure you account for those too.

At the root of the discussion is a decision of whether the money or the relationship is more important to you. It’s also probably worth evaluating if the person asking for the money simply sees you as an ATM or is someone who is truly in need. Regardless, once you open that door, don’t be surprised if it opens again and again, and be prepared to deal with that if it does happen.

My personal advice is to stay away. Money issues change relationships, so keep money out of the discussion. As the Beatles said, you can’t buy me love.

By

Jason Hull, CFP®, was the co-founder of Broadtree Partners, a firm that acquires $1-5MM EBITDA companies. He also was the co-founder of open source search consultancy OpenSource Connections, a premier Solr and ElasticSearch firm. He and his wife FIREd (financial independence retire early) at 46 and 45, respectively. He has a BS from the United States Military Academy at West Point and a MBA from the University of Virginia Darden Graduate School of Business.

You can read more about him in the About Page.

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