Close relationships can affect your financial decisions, and sometimes, not for the better. A Bankrate survey found that nearly half of people who helped a loved one financially experienced a “bad” outcome—lost money, a damaged credit score, or harmed relationship.
But does mixing family and money have to be so incompatible?
Not if you plan accordingly!
Perhaps the best way to protect your financial situation and relationships is with ample thought, consideration, and preparation concerning loaning money.
If you’ve been in a situation where a loved one has asked you for money, you know firsthand how awkward the conversation can be—clammy hands, increased heart rate, averting gazes, etc.
To help you prepare for these future requests (the holidays aren’t too far away), here are key things you need to know before loaning money to family and friends.
Don’t Feel Pressured to Say “Yes” On the Spot
A common response to an uncomfortable conversation is doing everything in your power to get out of it.
Money is a sensitive topic for many, making it tempting to assuage your discomfort by immediately filling the request.
But before lending money to loved ones, take time to self-reflect and think about how the exchange might affect you financially and emotionally.
Only Lend Money to People You Trust
It’s natural to want to help those close to you, especially if you have the means and ability.
But there is a lot of emotion that comes with money. If you don’t trust that the person will hold up their end of the bargain, the loan may be more stressful than it’s worth for both parties.
As a general rule of thumb, only give money to family you don’t plan on them returning. If your financial situation hinges on getting that money back, you may want to think more carefully about agreeing to a loan.
Consider Asking for Collateral
Collateral is an asset you accept as security in exchange for extending a loan.
For example, a restaurant may ask to hang on to your driver’s license if you need to run to your car for your forgotten credit card. Hey, it’s either that or dish duty!
In terms of your family, collateral might only be helpful if you’re loaning a large sum of money, like a down payment on a home, credit card debt bailout, etc. Your financial advisor can help you determine appropriate collateral and next steps depending on your circumstances.
Say No When You Need To
Remember, just because someone asks you for a loan doesn’t mean you have to say yes.
It’s okay to say no! Whether you can’t afford it, don’t want to, or the purpose of the loan doesn’t make sense to you, you’re allowed to turn down the proposal for any reason.
That said, money can be a tricky topic in relationships. Being compassionate yet firm in your decision can help alleviate feelings of rejection. It may also help provide the requester with context as to why you can’t give them the loan.
At the same time, it’s essential to stand by your decision. Your wallet, and your relationship, will thank you later.
Making The Loan IRS “Official”
Before extending a loan, it’s critical to understand that it’s often not as simple as writing a check.
The written agreement is the most important piece of loaning money to others.
Whether it’s $1,000 or $10,000, it’s often best to get the repayment terms in writing. The agreement can help prevent delays in repayment and avoid any confusion. It also adds a layer of formality and authority to the loan.
Plus, the IRS requires that all loans between family members have a signed and written agreement with a fixed repayment schedule and a minimum interest rate. You can find the most current Applicable Federal Rates (AFRs) here.
Discuss Charging Interest
As mentioned, you’ll want to have a minimum interest rate listed in the loan agreement. You can use the Applicable Federal Rates (AFRs) as a guide for the rate.
The IRS expects you to charge a particular minimum interest on a loan. Even if you fail to collect this interest, you can still be taxed as if you did. This interest is called “imputed interest.”
Work with your financial and tax advisors to determine the appropriate interest rate for your situation.
Try Not to Micromanage the Money
Putting a considerable amount of your money in someone else’s hands is scary. Nevertheless, try to avoid controlling the borrower’s spending habits or micromanaging their financial decisions.
Instead, focus on what you can control, such as creating a detailed repayment plan or limiting the amount of money you loan.
Only Make the Loan If You Can Afford to Lose the Money
Creating boundaries for loans to friends and family can help preserve relationships and minimize potential problems.
Try making a list of questions you need your borrower to answer before you agree to the loan:
- What do they need the money for?
- What other debts do they have?
- Have they budgeted for repayment?
Remember, don’t give a loan if you can’t afford to lose the money.
Even loved ones with the best intentions can encounter difficulties in paying back their loan. From hurricane disasters destroying homes to COVID-19 causing many to lose their jobs, there is simply too much unpredictability in our lives to ever completely guarantee repayment.
Even if you have a contract or collateral, the loan default can still greatly impact your relationship. For this reason, many financial planners recommend not lending any amount of money that you’re unwilling to part with.
Can You Gift Instead of Loan?
Giving money to family and friends is a big deal, and in most cases, you and your loved one would benefit from a formal loan agreement.
But if you’re simply looking at helping your loved one out, you can give them the money without a formal loan agreement via a gift. You’ll just want to watch out for the gift tax limit, which is $16,000 in 2022 (and $17,000 in 2023).
Before handing out loans to loved ones, getting a third party’s opinion is usually a good idea. Our financial planning experts at Chladek Wealth Management can review your family and friends’ money requests and help you make an informed decision.
Schedule a call with our team today.
The contents of this article are for general information and educational purposes and should not be construed as specific investment, financial planning, tax, accounting, or legal advice. Please consult with a professional advisor before taking any action based on the contents of this article.
All investment and financial planning strategies involve risk of loss that you should be prepared to bear. We cannot guarantee any investment performance whatsoever, and past performance is not indicative of potential future returns.