Somewhere in the back of our minds, we all have a mental list of the types of contacts that we dread receiving. First and foremost is the call in the middle of the night, informing us that a loved one is sick, injured, or dead. Next is probably the fear of receiving a letter from the IRS. If you are like me, high on your list is the dread of receiving a request from a friend or relative to borrow money.
Let me introduce to you a new term---“social loans”---- loans between people who know each other. The decline in the economy has seen a corresponding doubling of social loans in the last 18 months. The reasons are obvious: the economy in general, job losses, and the drying up of credit through traditional means. The need is obviously very real, but the cost of lending to family and friends can be very great, in terms of both money lost and relationships damaged. Readers of my earlier columns will remember that I have pointed out many times that money issues are the chief cause of family conflicts. Let’s look at some concerns that lending to family and friends raise, and then some possible solutions.
While we want to help our family and even close friends through hard times, we naturally wonder what loaning them money will do to our relationships. What if they can’t repay? What if they won ‘t repay? What tensions will it cause in the family? Will we dread going to family reunions? If I lend to my relatives, what will my spouse think? Will she or he resent it? If I lend to Cousin Gomer, will he pester me for more? Will the money I loan make a difference in my relative’s life, or is it just “throwing good money after bad?” I know that my sister desperately needs money, but I just can’t afford to help her. Should I bail my grandson out of debt again?
First of all, decide if you can afford to make the loan. Can you afford the risk of losing your money if the borrower either can’t or won’t repay? If you can’t afford the risk, don’t make the loan. Second, decide if it would be best to make a loan or make a gift. A loan carries with it expectations of repayment, and if those expectations are unmet, then relationships suffer, and suffer, and suffer………… Third, if you decide that you can make a loan, treat it like a business transaction in all respects. Get a promissory note with a reasonable interest rate. Please note that the IRS imposes restrictions on certain interest free loans, so get professional advice. Get security for the loan. Security can be a mortgage, an assignment of wages, a vehicle title, or valuable collateral that you can hold, such as stock certificates, jewelry, etc. Fourth, get a third party advisor, such as your CPA or attorney to close the loan and collect payments. This helps to remove the personal aspect from the transaction. Make it plain to the borrowers that in the event of non-payment, they will be dealing with the advisor and not with you. It is human nature to believe that our family and friends won’t be as tough on us as will a disinterested third party. However, from the lender’s perspective, the more businesslike you can make the lending transaction, the more seriously the borrower will take it.
If the borrower can’t or won’t repay, then all is not lost. You may be able to take an income tax deduction for a bad debt. These losses are treated as short term capital losses. They may be used to offset capital gains, and the excess can be used to offset ordinary income to a maximum of $3,000 per year. Unused losses may be carried over to future years. In order to get a tax deduction for a bad debt, it is essential that you have the proper documentation. At a minimum, this means a signed promissory note and evidence of your attempts to collect on the debt.
What about co-signing a relative’s or friend’s loan with a bank or other commercial lender? Bad idea! When I was growing up, my father told me time and time again to never, ever co-sign or guarantee someone else’s note unless I had both the ability AND the intention to repay the debt in full. If you co-sign a loan, the chances are very high that you will have to make good on it. This is called being surety for a debt, and we find warnings against this practice going back to ancient times. Having to pay someone else’s loan you co-signed is like showing up at a banquet after the meal is over, and being forced to pay the bill.
Social loans to family and friends often create more problems than they solve. While lost money often can be replaced, broken relationships are so difficult to repair. Some of the truest words ever written about money and relationships are found in Proverbs 22:7, “…the borrower becomes the lender’s slave.” (NASB). Slavery is the most unequal and undesirable of relationships.
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