Loan Money to Friends and Family Without Getting Burned

NEW YORK (MainStreet)—In a 1998 episode of the classic sitcom that bears his name, Dr. Frasier Crane offers to loan Roz Doyle $1,500 to help her through what they both hope will be a period of brief unemployment. "You can just pay me back whenever you'd like," he says, handing her a check. "This is your money to do with as you see fit."

Fans of the show won't be surprised to learn that Frasier later becomes agitated when he feels that Roz is spending the money frivolously on spa treatments, fancy clothing and expensive perfume. Against everyone's advice, he eventually confronts her about it. She immediately grows angry and combative. He gets embarrassed and defensive. They have a big fight, but — because this is TV — everything is resolved before the 22 minutes of airtime plays out.

In the years since that episode first aired, rising unemployment and tightening credit have made real-life loans between friends and family members increasingly common. And they're not always used solely to navigate a rough personal patch. One recent study found at least 7% of all homebuyers now rely on such assistance, while another found 14% of all business owners are turning to those they know to cover costs.

When handled as poorly from start to finish as Frasier's loan to Roz, these transactions rarely end on such an amicable note. But it doesn't have to be that way, experts say. You can actually lend money to someone who is dear to you, help them out of a jam, get repaid and remain close.

The key is handling the situation just like any other business transaction: don't loan blindly, lay out the specifics so there are no misunderstandings, and put it all on paper.

If you do it, do it right.

Recent tough times may have aimed a spotlight on such loans, but they are hardly a new phenomenon. "People have been borrowing from, and lending money to, family members and friends for centuries," says Tim Burke, founder and CEO of National Family Mortgage. His company, launched in 2010, helps those who want to finance private home mortgages for friends and family.

One thing that is different today, he says, is the need to formalize the process in order to satisfy stringent legal and tax requirements. One thing that isn't, is the stressful nature of discussing money problems with those close to us — something fraught with potential pitfalls that few fully anticipate. "Money is a polarizing subject from the outset, and circumstances surrounding these requests often make that worse," Burke says.

The first step in making these kinds of loans work for everyone, therefore, is putting the emotional component on the shelf. "You have to make this decision with your head, and not your heart," says Gail Cunningham, a vice president at the National Foundation for Credit Counseling.

Some of that may make both parties uncomfortable, she adds, but it's the key to ensuring such loans will be made and repaid successfully — and the relationships involved won't fall apart over them.

Foremost, Cunningham says, "is treating this like any business decision." This means preparing for an open discussion and giving yourself time to consider your answer. Getting details on what the money will be used for — this adds a measure of accountability and can assist you as you weigh your options — and why you are being approached rather than a bank. Thinking about ways you might help the recipient help themselves in the future, like guiding them toward financial or budget counseling.

And never consider anything other than a cash loan. Opening a credit card account in your name is often a recipe for disaster.

 

Put it on paper, and get it signed.

Before any money changes hands, put everything in writing and have the document signed by all parties. This can be accomplished with something as simple as a state-specific promissory note, available online for free, or as formalized as the officially registered paperwork prepared by facilitators like National Family Mortgage. Even the most rudimentary document should also be notarized, which may give more legal standing in cases of default.

The document itself should emphasize that this is a loan, not a gift. It should outline all terms, including how and in what timeframe it will be repaid, and what will happen in the case of default — late fees, collection process, legal action, etc.

It should also note what interest rate will be charged, which is essential in order to avoid gift taxes on the lender. "You don't necessarily have to collect the interest," Burke notes, "but you have to prove on your income tax return that you are earning it." Such interest, he adds, must be at least the "applicable federal rate" set each month by the Treasury.

Finally, remember that you can always say no. Most experts advise never lending more than you can afford to lose, and they say not to conclude a deal if you're not totally comfortable with the proposal or the lender-borrower relationship. Don't let guilt guide you to the wrong decision, they add.

If you do decide to go ahead, stay in communication but distance yourself from the transaction once all of the i's are dotted and t's are crossed. Suggest the recipient contact you immediately if they run into trouble, but recognize the money is no longer under your control and resist the urge to micromanage how it's spent.

Unlike Frasier and Roz, we don't have scriptwriters and a 22-minute limit to make all hard feelings go away.

--Written by Howard Roth for MainStreet

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