If you feel queasy when friends or relatives ask you for money, you know why there are contracts for such things. Before you ruin a relationship (let alone your own finances), make sure you lay down some enforceable rules.
Why Friends Ask Friends for Money
To avoid bank fees or getting turned down for bad credit—or just to have a more relaxed borrowing experience—people often ask family or friends for loans to start a small business, purchase a home, get back on one’s feet after a financial crisis (such as a divorce), or simply because the person is young and hasn’t yet established enough credit for a car loan. According to the National Association of Realtors, 7 percent of home buyers received a loan from a friend or relative to finance their home last year. Fourteen percent of business owners reported asking friends and family for loans, according to the National Small Business Association.
Lending Money: What to Include in a Contract
While a handshake might seem like enough assurance that you’ll see your money again, an oral contract isn’t always enforceable unless you have witnesses willing to testify to the terms of the agreement.
A written contract or promissory note, signed by the responsible party, should include:
- Time. Set up a specific payment schedule, and keep a log of payments made (including copies of checks or other pertinent documents). Also, be aware of your state’s statute of limitations for suing on unpaid debts.
- Attorney fee provisions. Specify that your pal will pay for anything you spend to collect an unpaid debt—especially if your attorney fees are likely to be larger than the amount owed. If the amount is small (say, $5,000), you can file in a small claims court.
- Signatures. Have your borrower sign the contract in the presence of a notary.
- Collateral. If possible, hold on to something of your borrower’s temporarily until the loan is repaid, or at least specify in the contract an item you will receive if your friend can’t come up with the money by the agreed upon date. If your buddy really needs the money, he can let you hold onto his beloved iPod, skateboard, or DVD collection for a while—just include everything agreed upon in the contract.
Mistakes to Avoid When Lending
When loaning money to a friend or family member, many make the same mistakes.
Be careful to avoid the following:
- Loaning to someone you won’t be able to track down. Have the responsible party’s current mailing address; should you have to sue this person, you’ll want to know where to find them to serve a complaint. Also, don’t loan money to anyone you don’t want to hound for money.
- Charging too much or too little interest. Check your state’s usury laws to check the maximum legal interest rates that can be set for loans. Setting an illegally high interest rate for your borrower could get you into trouble. This doesn’t mean you shouldn’t charge any interest, though; the IRS requires intra-family loan rates to reflect the current Applicable Federal Rate (which changes monthly), so if your friend or family member is borrowing money from you to avoid paying interest, you may both want to reconsider. Not charging a high enough interest rate could result in the money being subject to a gift tax.
- Communicating too little—or too much. You should always check up and keep communication open with your borrower; be proactive if payments aren’t being made, even if it means readjusting the payment schedule a bit. Don’t, however, be too controlling about what your friend is doing with the money or other personal decisions that involved their finances.
- Lending more than you can afford to lose. Unless you’re a licensed lender or can afford an experienced business lawyer, don’t assume you’ll ever get a cent back from your pals. If you’re not willing to simply give the amount away on a pay-me-back-if-you-want basis, don’t lend it at all, since saying no may damage your relationships less than having to hound friends for money.
