This article is reproduced with permission from NextAvenue.org.
In these tough times marked by high inflation and a contentious recession, many households are feeling cash-strapped and pressured by rising spending and interest rates. The first line of defense for many is asking family and friends for money to stay afloat.
As a financial planner, I have seen many of my fellow first generation wealth builders and sandwich generation wealth protectors grapple with the precarious decision of whether or not to lend money to family members and friends.
FOG (fear, obligation and guilt) money and heartstrings cloud their judgment as they consider the loan decision. They go from wanting to lend money and get loved ones back on their feet to struggling to trust someone who is already in debt.
Don’t miss: My girlfriend and I sold our house in Florida. Our profit of $200,000 was transferred to his account. She refuses to give me my fair share. What’s my next move?
Think about it before lending money
If you’re considering lending to a family member or friend, here are some questions you should ask yourself before taking the leap:
- Are you ready to lose money? Lending money to anyone is risky, especially if it is not a bona fide business transaction. To keep repayment expectations flexible, you may need to view the funds “as a gift instead of a loan,” as I explained in a recent CNBC segment.
- Are you ready to let the money jeopardize your relationship with the borrower?
- What is the emotional capacity of the future borrower when handling business with family or friend?
- Will you be able to control your emotions and interact calmly with a delinquent borrower during your next family reunion or vacation?
Shakespeare opined on keeping drama out of the relationship equation stating, “Neither a borrower nor a lender often loses both himself and a friend.”
Also see: My friend cleans, cooks and takes care of my child. I pay him $50 a day. Am I taking advantage of her?
Questions to Ask a Borrower
At the same time, you must be prepared to ask important questions of the potential borrower. Conversations about money are difficult for even the most secure relationships, and your new role as a lender requires you to be comfortable asking relevant questions such as:
- Why do you need money? The answer to this question should clearly define the objective and define the terms of the engagement.
- What is your plan to repay the loan? This will give you insight into the intent and strategy of the potential borrower.
- Is your credit score 700 or higher? If not, what affected your score? The answers to these questions should open a window on the situation and the behavior of the potential borrower.
- Why do you think I have money to lend? The answer will signal what the potential borrower thinks of you and your financial situation and set an ambitious goal for them.
If you don’t feel comfortable asking the questions or the potential borrower is reluctant to provide answers, you may both realize that a loan from you is out of the question.
Also see: Am I stupid to keep my IRA invested in stocks?
Always get it in writing
If you decide to take on the role of lender after answering the essential questions above, consider codifying your agreement. Draw up a legally binding promissory note to include terms such as total amount borrowed, interest rate, repayment schedule, overdue payment fees, and default terms.
Add the loan to your list of assets on your net worth statement and add language to your will or trust to ensure that your estate will collect your investment upon your death. To help with its legality, find out if your employer offers a legal benefits service or secure online resources such as RocketLawyer, Upwork, and Pigeon Loans.
Don’t forget the taxman
Family loans also have tax implications. The IRS issues monthly guidelines for setting interest rates on family loans, known as Applicable Federal Rates (AFR). The AFR rate ensures that personal lenders avoid pricing below market interest rates to avoid inheritance and gift taxes.
See: You’re not too young to make a will. Take care of your family with a simple “I love you, honey” estate plan
Although you may not consider yourself a wealthy person, it pays to incorporate a reputable framework to guide your loan terms. Also, it should be noted that loan interest is taxable income for the lender. Consult your tax advisor on the best way to set interest rates and report interest income.
When asked to borrow your money, think carefully about what is really at stake and the reward received by both parties for the risk taken.
Certified Financial Planner Lazetta Rainey Braxton is co-CEO and co-founder of Wealth Partners 2050 and CEO and Founder of Lazetta & Associates. She is passionate about amplifying diversity, inclusion, equality and belonging in the financial planning profession and does so through financial planning, public speaking , writing, consulting and coaching. She was named 2021 Crain’s New York Business Notable Black Leader and Executive as well as one of Investopedia’s Top 10 Financial Advisors in 2020 and 2021. She is on a mission to create wealth for the common good.
This article is reproduced with permission from NextAvenue.org© 2022 Twin Cities Public Television, Inc. All rights reserved.
More from Next Avenue: