In life, there are a few certainties that you can rely on. If your friends or family think you have money to spare, many are likely to ask for a loan. Responding to a request from friends or family can be difficult, and there several things you should consider before you agree to make a loan:
1. Help ensure the loan won’t damage your relationship with that person.
Loaning money often adds significant stress to a relationship. Before you loan, you have to accept the reality that the loan may not be repaid in a way that you consider acceptable. So ask yourself ahead of time if you are willing to take that risk in your relationship.
Always remember that just because they ask for a loan doesn’t mean that you have to give the loan, even if you have the money available. Often times it can help to explain your reasons to deny a loan. However, it’s best to try to understand their position and see their perspective before you start to explain how you feel.
2. Put the entire agreement in writing.
When extending a loan, put your entire agreement in writing. Make sure to include the principal balance, interest rate, repayment terms, due dates, any privacy agreements, provisions for late payments and consequences for delinquency.
We recommend the person you are loaning the money to come up with several contingency plans for what they will do if you don’t loan the money, and several plans if they default on their agreement. This exercise may help you decide whether you can discuss the money in a rational, respectful way.
3. Exercise extreme caution before cosigning a loan.
When you cosign a loan, including school loans, you are signing a legal document that says you are responsible for the entire debt and any fees that may be incurred. If the primary borrower falls behind in payments, whether you have been notified or not, you have agreed to be held accountable for the debt and the fees. Therefore, it is extremely important to consider all of your potential risks before you cosign.
4. Ask for collateral.
Don’t be afraid to ask for a lien on a house or a car if you are loaning significant sums of money. That way if the person files for bankruptcy, your claim will have precedence over general creditors without liens.
5. Keep all documentation of the loan with your estate files.
If something happens to you during the loan period, there may be consequences to other family members and to your estate if the loan is not properly documented and accessible upon your death or disability. If you need help organizing your estate paperwork, see our blog series Documents You Need Before You Die.
6. Don’t keep the loan a secret.
If you make a loan to a family member, informing other family members of the contractual agreement may abate the feeling that you are giving preferential treatment.
7. Discuss what defines common courtesy.
Discussing a loan agreement with family might be acceptable, but is it acceptable at the Thanksgiving dinner table in front of a large group of people? Talking through your expectations and concerns before you loan can help pave the way for future amicable discussions.
8. If you agree to gift the money rather than loan the money, there are taxable ramifications that are specific to gifting.
If you choose to gift money instead of loaning it, contact your financial advisor to help ensure that you are properly gifting your assets so that you and the person you are gifting to do not receive unexpected tax consequences. As always, it helps to have a financial planner who is qualified to review your entire financial situation. We recommend working with a Certified Financial Planner. See our Annual Gift Tax video to see what the gifting limits are for 2015-16.