The Pitfalls of Lending Money to Friends and Family

With an onslaught of bankruptcies, hundreds of thousands of businesses shuttered, and millions of Americans out of work or furloughed, these are undoubtedly challenging economic times as the coronavirus continues to upend daily life. Some folks may begin looking for financial assistance among those closest to them — friends and family members. Lending money to loved ones can be fraught with challenges and pitfalls, and should be approached with caution. We asked financial experts across the country to weigh in on the mistakes to avoid when providing cash assistance to friends and family. Here are their tips for avoiding the frustration and hassles that often come with such loans.

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Perhaps the No. 1 rule of thumb when considering lending money to friends and family is to first ask yourself: Can you afford to provide the money as if you’re giving it away forever? “If the answer is no, then you can’t afford to be philanthropic,” Mark Charnet, founder and CEO of American Prosperity Group. “If the answer is yes, then you must dig deeper into the request based on the person’s history, personality and trustworthiness.”

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Those who decide to proceed with such a loan should not do so without developing specific parameters in writing. “A contract must be drawn up for clarity … and to prevent misunderstandings,” says Charnet, who adds that all parties involved must sign the contract. “For example, if you lend money to your brother, your sister-in-law must sign the contract, too.”

Another word on drafting that contract: You need to get granular, drilling down to exactly how much repayment installments should be, when the payments should be made (monthly, weekly, quarterly) and when repayment begins and ends, says Jully-Alma Taveras, founder of Investing Latina. “Being able to help a family member out during hard times is a great privilege, but it’s very important that you set very clear expectations,” says Taveras. “Sometimes people will say yes — which can be very easy — but then not address the hard part, which is stating what is and isn't acceptable.”

Remember the loan you make to a friend or family member is a business arrangement and you must treat it as such. “If you agree that the loan repayment is due every other Saturday, and the friend or family member pays you on Sunday, do not let it pass,” says Taveras, who suggests making it a point to discuss the tardy payment. “Remember that you want to treat this as a true business transaction.”

Here’s another no-no when a friend or family member taps you for a loan: chastising the borrower for the situation that put them in financial trouble in the first place. This will accomplish nothing positive, and hopefully the person has since learned from the situation. “Asking for financial support from a family member can be humbling, and the borrower is not looking to be berated for creating the situation, just helped out of it,” Charnet says.

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While you shouldn’t guilt the borrower, you should be clear on what exactly the money will be used to pay for. “You wouldn’t want to support bad habits, for instance, gambling, drinking, or any other vices,” says Timo Wilson, CEO of ASAP Credit Solutions.

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Remember, we’re still in the middle of a pandemic, and there’s no way of knowing how long the person you give money to may need to repay it. “It’s important to remember we don't have an end date, and we have no clear idea on how the economy could continue to be impacted should we face further lockdowns and continued social distancing,” says Ethan Taub, founder and CEO of the bill management platform Billry.

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It should already be clear these are uncertain times. While your own financial situation may seem solid enough, things can change on a dime. So lending money from your own nest egg may not be the wisest move. “You cannot guarantee your own financial safety, so needing that money back could become quite desperate, quite quickly,” Taub says. “These sorts of possibilities, which usually seem unlikely, are now very real and could tear families and friends apart.”

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Another pitfall is lending more than you’re truly capable of parting with. “Some people can sometimes be too sympathetic and be too generous at the cost of their own financial situation,” says David Meltzer, CEO of East Insurance Group.

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It’s not a good idea to brag about your income to friends or family members, particularly when they’re seeking a loan. “If you don’t talk about your income and finances, saying no to a family member will be easier because they won’t think of you as a greedy person,” says Leif Kristjansen, personal finance expert, early retiree, and creator of the website Five Year FIRE Escape.

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There could very well come a time when the person you lend money to misses or skips a payment (or two). Be prepared. “When payments are missed, the lender starts to become very judgmental about how the borrower is spending money thinking — they can’t pay me back, but they can go out to dinner? Get their nails done? Host a party?” says Michael Hess, a wealth management adviser with WestPac Wealth Partners. “After watching how money is being spent the lender can start to think ‘Do they even care about paying me back?’ And then the elephant in the room is even bigger.” The bottom line is that lending money to friends and family is a tricky situation. If you want to help someone financially, make sure you’re prepared for what lies ahead and the likelihood of slow repayment, as people who borrow from family and friends generally do not take such loans as seriously as they might a loan from a bank.

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It's important to separate your personal and business relationship with the borrower, though this can be easier said than done. “Be sure to make time outside of family functions to discuss the loan,” Taveras says. “Give yourself the grace to enjoy the time with family without bringing up the money and feeling stress. The more consistent you can become with separating the two things, the less tension you will feel in the long run and in the term of the loan.”

Seeking legal input and guidance can help avoid feuds when lending money. Though “you might want to keep it as friendly and informal as possible,” says Holly Andrews, managing director of KIS Finance, “treating things more professionally will keep arguments at bay. And if things don’t go to plan, then you will have legal backup.”  

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In the very real event a friend or family member never pays you back, don’t forget to at least declare your loss. “Don't make the mistake of not writing off the debt in your taxes,” Taveras says. “Nonbusiness bad debt like a loan to a friend or family member can be written off in your taxes using short-term capital loss Form 8949. So, if you’re unable to recover your loan, make sure you at least benefit by writing it off as a loss and reducing your tax liability.”

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One last tip, from Charnet of American Prosperity Group: You can say no to a loan request. Sometimes that can be a better option than the possibility of fractured relationships, hard feelings or weeks, months, and years of asking loved one repeatedly for money to be paid back.

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