How to Loan Money to Friends and Family

Has a friend or family member asked you for a loan? This can be a difficult situation. On one hand, you likely want to help them out. On the other hand, you don’t want to be out the money or put a strain on the relationship. The trick is to know how to loan money the right way.

Before you agree to loan any money to a friend or family member, think about how reliable they are. Can you depend on them to repay the money? Secondly, you might want to ask them what they need the money for and why they can’t take out a personal loan. The answers to these questions might provide some clues as to whether you should lend them money or not.

For instance, if they need the money because they’re past due on bills, this could be a sign that they may not have the funds to repay the loan. If they can’t secure a loan due to bad credit, they may not be very reliable. However, if they simply have limited credit due to their age or other factors, it might not be an indicator.

If you decide lending money to your friend or family member is the right option for you, keep reading for tips to make the process as seamless as possible.

How to Loan Money: Lending Money vs. Cosigning a Loan

If you can choose between lending money and cosigning a loan, lending money is probably the best option. When you lend money, you can do so on your terms. You determine the amount of money, payment terms, and interest rates. By cosigning a loan, you’re stuck with the terms and conditions of that loan.

However, that’s not the major problem with cosigning a loan. The biggest issue is that if your friend or family member decides to stop paying on the loan, you’re responsible for paying the balance due. Additionally, your credit could be significantly impacted, especially if your loved one fails to make on-time payments and doesn’t tell you.

Alternative Lending Option

Before you hand over any money, you might want to encourage your loved one to apply for a personal loan with bad credit. Help them determine what their credit score is so they can decide if applying for this type of loan is a viable solution.

Credit.com’s Free Credit Report Card can be a good source for this information. This report card provides a free credit score, along with notes on what you can do to improve your scores. For example, you can raise a credit score by paying down high credit card balances, disputing credit report errors, and using a starter line of credit, like a secured credit card or credit-builder loan, to establish a solid payment history.

Keep in mind that loans for those with bad credit often come with higher-than-average interest rates. However, making on-time payments can help them start building their credit.

What’s the Smart Way to Loan Money?

If you’re willing to lend money to a loved one, there are a few things you should keep in mind, including getting everything in writing and setting a firm payment schedule. These steps can protect you if you go to court.

Here are three tips to keep in mind when considering how to loan money.

1. Get It in Writing

While you may be dealing with friends or family members, loaning them money is still a business deal. Make sure to get all the terms of the loan in writing. This will prevent any confusion and provide you with the necessary evidence if you need to go to court to collect the money.

If your loved one is borrowing a small amount, you can probably write the details of the loan agreement on a piece of paper that all involved parties sign. Be sure to include the total amount due and any added fees, such as late payment fees or interest.

For larger sums of money, you may want to have your attorney draw up a formal contract for all parties to sign.

2. Set Fair Interest Rates

You might be a little hesitant to charge interest on the loan. However, this may be the only way to protect yourself from paying gift tax. Being able to prove you’re charging interest can help you show the IRS that it’s a loan and not a gift. This factor is especially important when lending larger amounts of money.

When deciding how much interest to charge, you want to be fair to both yourself and your friend or family member. Be sure to set an interest rate that’s higher than the amount you could have earned having the money sit in your bank account. On the other hand, you may not want to charge as much as standard lenders.

The best option is to talk to your friend or family member to negotiate a deal.

3. Create a Clear Payment Schedule

Don’t make the mistake of telling your loved one to pay you back whenever they can. This leaves the payment terms up in the air. Plus, your friend or family member may never feel financially able to repay their debt.

Instead, create a clear payment schedule that states exactly how much is due and at what intervals. For example, you can create a schedule that requires them to pay $100 on the first of each month until the debt is paid in full. You should also detail what forms of payment you can accept, including cash, money order, check, or PayPal.

It’s a good idea to start a journal that tracks the exact date and amount of each payment. It’s important to always list additional fees, such as late payment fees, separately. You should also provide your friend or family member with a receipt for each payment made.

Lending money to your friends or family members can be a viable option if you have the funds to spare and trust the person borrowing the money. But don’t go into this type of agreement without getting everything in writing. Instead, follow the above tips on how to loan money.

If you decide not to lend money to your loved one, encourage them to take steps to improve their credit, such as signing up for Credit.com’s ExtraCredit® credit monitoring subscription to see 28 of their credit scores and what factors are affecting it most. This way, they’ll be able to work on the areas affecting their credit to better be able to secure the funds they need in the future.