Money Matters - The Four Costliest Lending Mistakes

Suze Orman

It's never easy to say no to someone you love, especially when they come to you in need of cash. But lending a financial hand can leave you out of money and out of sorts with your friends and relatives.

I often hear from people who have loaned money to someone they care about deeply, only to have to deal with the fallout when they don't get repaid.

Four Pitfalls to Avoid

According to Circle Lending, a company that helps formalize loans between individuals, about 14 percent of loans between friends and family end up in default, compared to just 1 percent or so for bank loans. To protect yourself financially and emotionally, make sure you don't fall for my top four costliest mistakes individuals make when loaning money to friends and family:

1. Not being suspicious enough.

When someone comes to you for a loan, your first thought should be, Why? That is, why do they need the money, and why are they asking you for help.
Be incredibly cautious about why they need the money. A friend who gets hit with unexpected health-care bills and is worried about putting them on his credit card at 18 percent interest is a lot different from a friend who needs you to bail him out to settle a gambling debt, or to finance a vacation.

You also need to think hard about why they haven't been able to get a loan from a more conventional source. If a family member comes to you for a loan to start a business, you should ask -- out loud -- why can't he or she get a loan from a bank or the Small Business Administration.

My point is that there are plenty of folks in the business of lending money. If your relative or friend can't get money from one of them, it should set off an alarm for you.

2. Lending what you can't afford to lose.

Never loan money that you truly need. The best litmus test before you agree to give a loan is to ask yourself if you would be comfortable giving the money away as a gift. If the money is too central to your own financial well-being, then just say no.

There's no guilt or shame in that. If you're dealing with someone who truly loves you, they'll understand. All it takes is a bit of honesty: "As much as I would love to help, I don't have that sort of money to share right now, given all my bills and retirement goals."
You aren't saying, "No, I won't loan you money." You're saying, "My own financial situation makes it impossible for me to help you right now."

3. Overlooking the extra risk of loans for new businesses.

Say your brother is excited about a business idea, and he wants you to loan him $20,000 to help with the startup costs. This loan is the riskiest of all; your money is actually an investment in a business that may never make a penny.

The only way you're going to be repaid is if the business is a big success. But that's a big "if." It's important to be extra careful with such "dream" loans; the odds of repayments are a lot lower than advancing money to someone who has a steady source of income that will allow them to quickly start repaying you in installments.

4. Skipping the formalities.

Handshakes, hugs, and kisses are not good enough for sealing a loan agreement. Put everything in writing. In fact, that's another good way to size up the credibility of the person who needs your money: They should tell you right off the bat that they want to sign a formal loan document that spells out all the terms of the deal.

That's a sign that they respect not just you, but the importance of what they're asking you to do. If you have to ask for a contract, that should be yet another warning signal.

Do the Paperwork

You can purchase a simple loan document (called a promissory note) for $10 from legal services web site Nolo. Once you fill it out, all parties should sign it in front of a notary; it's just a nice bit of formality to have in your pocket in the event that anything goes wrong.

Spell out the specifics in the note: What interest rate you will receive, when the payments are due, how much is due with each payment, and what penalty will be paid for a late payment.

Piquing Your Interest

Yes, you read that right -- you should charge interest. The IRS will actually let you get away without the interest requirement if all loans between two parties are under $10,000. (Over that amount, you must charge interest or risk running into a rat's nest of tax issues involving the gift tax.)

No matter how small a loan, charge interest. Again, it's about respect: The person you're loaning money to needs to take this very seriously. I recommend using the Applicable Federal Rate published by the IRS.

Actually, it's three different rates -- one each for short-term (under three-year), midterm (between three- and nine-year), and long-term (more than nine-year) loans. The rates are tied to the commensurate Treasury rates; right now, all three are hovering around 5 percent. By the way, that interest is taxable.

Keep to a Schedule

I also recommend starting the repayment period as soon as possible. Don't settle for a lump-sum promise down the line. That puts too much pressure on you to be patient, and on your friend or relative to come up with a big chunk of cash all at once.

Instead, set up a monthly or quarterly repayment schedule and spread it out over an agreed-upon number of months or years. In fact, the smartest move is to have the payments deposited directly from their bank account into yours.

That reduces the chances of anyone getting sloppy or lazy -- and increases the chances that your personal relationship won't be undone by your financial relationship.

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