What to Do When Friends and Family Want to Borrow Money

You’ve started earning extra cash on the side and saving money on your regular purchases, and you’re finally seeing that bank balance rise — congratulations! (And let us know if any of our advice helped — we love reader feedback.)

However, if your friends and family haven’t reached that point, they might turn to you when they need financial help. Helping a loved one out with a loan is a great gesture, but if you’re not careful, your generosity could turn into resentment on both ends of the deal.

That’s just what happened to a friend of mine. She and her husband once loaned $10,000 to the husband’s niece, who promised to pay them back — but it was a verbal transaction. After a year went by with no repayment, my friend was frustrated with her husband and they were both mad at the niece, who now considered the loan a gift. They never did get the money back, and their relationship with the niece has never recovered.

If you’re thinking of helping a friend out — and even earning a little interest in the process — follow these simple rules to make sure the deal goes smoothly. Here’s how to make sure you get your money back and keep your friendship.

Put it in Writing

A funny thing happens when one person lends money to another: the borrower often remembers the transaction differently than the lender does. The loan might suddenly become a gift in the borrower’s mind, or the borrower might remember borrowing less than the actual amount.

This is nothing new: as Benjamin Franklin once said, “Creditors have better memories than debtors.”

A loan shouldn’t depend on anyone’s memory. Always put the transaction in writing. Some people think this formality is unnecessary among friends and family, that a verbal agreement and maybe a handshake are enough. Those people risk losing the relationship altogether when the deal sours.

Lending money is always a business transaction, so you need to draw up paperwork to keep emotions out of it. Here’s what you should put in your contract:

• Both names: the lender and the borrower
• The amount loaned
• The date you loaned the money
• The interest rate (more on this later)
• The date the loan is due to be paid in full
• The date the payments will begin
• The minimum payment and payment schedule
• How payments will be made (PayPal, check or automatic deduction from the borrower’s bank account)
• What the late fees will be (optional)
• What action you will take if the borrower defaults

Circumstances vary, so you should do your own research before drawing up a contract. RocketLawyer offers a free loan agreement template if you want to do it on your own, though consulting an attorney may be a good idea as well.

Sample Contract

[Your name] is lending money to [borrower’s name] in the amount of [amount of loan] on [date] at an interest rate of [interest rate] per annum.

Payments of [minimum payment] will begin on [date] and will be due in regular monthly installments on the [date] of each month and will continue until [date of calculated payoff]. Payments will be made by [payment method].

A late fee of [amount] will be charged if the payment is [how many days] or more days late.

[Borrower’s name] can pay the loan off at any time with no prepayment penalty.

If [borrower’s name] defaults on the loan, [lender’s name] will take legal action and [borrower’s name] will pay any collection costs.

You will have more legal standing if you have this document notarized, which could cost a few dollars. Find a notary service by searching for “notary + [your city]” or go to the American Society of Notaries.

Charge Interest

Many people wouldn’t think of charging interest to a friend or family member. However, charging interest, despite what you might first think, is a good idea for two reasons:

1. If you lend a large sum of money without charging interest ($14,000 or more, as of 2014), the IRS will tax the borrower, viewing the money as a gift. Charging interest helps show the IRS that the transaction is a loan.

1. Loaning any amount of money to a friend or family member without charging interest can result in resentment; the relationship no longer feels equal. But if the borrower is paying you interest, he’ll feel less dependent on you — which levels the psychological playing field.

So how much interest should you charge? There’s no need to enter the loan shark business. Charge enough to satisfy the IRS requirements, called the Applicable Federal Rate, and a little more than what you’d earn if you had the money in a savings account.

Now that you have everything set up, don’t comment or gossip about how the borrower is spending money. That’s not your concern. But don’t accept not being paid. If the borrower cannot fulfill the agreement, draw up a new repayment plan or take the action you specified in your contract. Stand firm and be understanding, but professional. Let the borrower know that this loan is important.

If you still feel that you cannot write a contract or charge interest, consider just giving the money away. Lending money without a contract can ruin a relationship — one that might be worth more than any amount of money.

Your Turn: Have you ever loaned money to a friend or family member? What happened?

Disclaimer: This article does not constitute legal advice; the author and The Penny Hoarder are not lawyers. For further information, please consult an attorney.

Laura Agadoni has a background in credit union marketing. Her articles appear in various financial publications such as The Houston Chronicle’s small business section, The Motley Fool, Yahoo! Finance, San Francisco Gate’s real estate section, Zacks, Arizona Central’s small business section and InsuranceQuote.com.