A guide to lending money to family and friends

Five years ago, Dorothy Fuscaldo, a personal trainer from Westchester County, NY, loaned $5,000 to a close friend, someone she considers her sister.

“She had problems at home, with her family, and she wanted to be alone,” Fuscaldo says. So Fuscaldo agreed to lend his money for a down payment for an apartment. A few months later, her friend decided not to buy her own house. Instead, she entered into a relationship and moved in with the person. Fuscaldo, on the other hand, never got his money back.

Although the loan has been a topic of conversation over the years and they remain close, Fuscaldo has never asked him for the money outright.

“‘I know I still owe you money, but right now I have this, that and the other,’ she recalled her friend saying, ‘Now what do you do. “

“What pissed me off,” Fuscaldo says, “is that she bought a motorcycle about two years ago. It wasn’t a necessary item, the medical bills, I would understand. It could have been my three thousand dollars.”

Even though it doesn’t seem likely, Fuscaldo still feels like she’ll get the money back.

What can we learn from her?

rules of the road

If Fuscaldo had spoken to Dennis Stearns, president of Stearns Financial Services Group in Greensboro, North Carolina, she might have done things a little differently.

Although Stearns doesn’t agree with some that it’s never a good idea to lend money to family or loved ones, he says, “we try to figure out what kind of situation it is and it often determines whether you should do it or not.”

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It also establishes the amount of structure and interest to be charged. Although his philosophy is based on parents lending their children money, he says it can also apply to other close relationships with a few caveats.

Stearns’ scheme for identifying good and bad borrowers includes three main types.

The first category that Stearns describes as “grounded”. These children have experienced temporary problems and may need a one-time solution. They tend to pay the parents back and it’s usually a very positive thing that they get help, so there’s not really any harm in the relationship.

“We’ve done two of those loans this week and we’re cheering them on all the time,” Stearns says.

He calls the second type “Accident Prone”. This child has occasional trouble and needs more structure in the loan in the form of written documents and also more coaching. They often need a family member or financial advisor to talk to them about the situation and how to prevent it from happening again.

The key is to make sure they don’t drift into type three, which Stearns calls “misfit.” This guy always seems to need more money, and money perpetuates other bad decisions or behaviors.

“These loans need a lot of structure and sometimes tough love, or not bailing them out, is the right answer,” he says. Type three people almost always need advice from a financial planner, accountant, or family lawyer.

How much interest should you charge in each case?

Stearns recommends using the short, medium, and long-term rates that the IRS charges under the applicable federal rate. The short-term rate of 0.57% is ideal for type one and some type two. The mid-term rate of 2.45% accounts for most type two and three loans, but in some cases the long-term rate of 4.11% is needed.

Business before friendship

While some of the same thinking applies, there’s a small difference when the loan funds a business venture, says Ira Bryck, director of the University of Massachusetts-Amherst Family Business Center.

These days, with the lack of access to capital, he says he sees a lot of small and medium-sized businesses that need money, and they go to friends and family to borrow, “even whether it’s really hard for friends and family to act professionally or say it’s just work.

If asked for a loan, Bryck recommends having the person sit down and give them a five-minute speech something along the lines of: If you’re going to use me as your bank, then I’m going to act like a bank and I’ll am going to ask what is your business plan, what is your return on investment, what kind of risk am I taking?

Online Solutions

“A bank wouldn’t lend you money without considering the three Cs: character, money, collateral. If I loan you $10,000 and you’ve invested $50,000, at least I know you have skin in the game, but if I fund the whole operation, that’s wrong,” he says.

“It pays to sit and think about the conversation, rather than having a knee-jerk reaction and saying the money is there because I feel guilty or there’s no way I am lending it to you.”

Other than that, Bryck says, as a family member, it’s important to only loan out what you can absolutely afford to lose. If someone is borrowing money for a business, there is a risk.

“Entrepreneur means someone who is willing to accept risk. If you lend to an entrepreneur, you are an entrepreneur,” he says.

Online loan solutions

Bryck recommends using an intermediary like . These are documents that formalize loans between people who know each other; users can create and customize their outline, says Sarah Deklin, Marketing Director of Virgin Money USA.

“It’s certainly not a bad thing to lend money to family and friends, and it can be extremely productive for both parties,” she says, “but what’s important is that you would speak in advance to make sure everyone is clear on what expectations are regarding the terms, timing, and repayment schedule.

Parents frequently use this service to lend children money for college or to buy houses, and friends and colleagues lend each other to start or fund businesses. There are state-level requirements on what constitutes an acceptable interest rate.

At the low end you have to charge a minimum interest rate or the lender could be subject to gift tax, and at the high end you have to charge interest rates below a certain threshold which varies depending on condition, otherwise it could be considered wear and tear.

“Usually, at the end of the day, what happens is the borrower gets a lower interest rate than they would get from a traditional lender, and the lender earns a higher interest rate. than it would on a typical fixed investment.”

Fuscaldo could have used Virgin Money US, legalzoom.com or nolo.com to personalize or upload a promissory note or other legal documents.

Bryck shared that, on a personal note, he twice loaned friends a few thousand dollars, and both times he was not repaid in what was “loosely defined as a reasonable period of time. “.

So what he ended up doing in each case was going to his friends and canceling the loan, saying their friendship was more important than money.

The unexpected result? Each time, Bryck ended up being reimbursed. Once, because his friend felt so ashamed of the conversation that he returned the money, and the second because the next day, ironically, his friend won some money and gave it to him.

At this point, it may be Fuscaldo’s best and only hope for a refund.

(This story has been updated since it was first published in January 2010.)

Troy M. Hoffman