Lending money to family and friends is a timeworn tradition--one that probably has worn out more relationships than it has helped. Still, if you've been fortunate enough to sock away some cash, can you say no to a child wanting to launch a business or a close friend who has run into temporary problems?
You can. But if you decide otherwise, consider that most business start-ups fail and that temporary problems have a way of becoming fatal ones. In other words, a lot of these loans go bad. About 14% of personal loans end up in default, according to Circle Lending, which formalizes loans between family and friends. That compares with about 1% of bank loans. So don't be surprised if your largesse ends up lost.
That may be fine if the borrower is in your will anyway and the wealth transfer doesn't run afoul of federal limits on tax-free gifts. But generally it is in the best interest of all involved to take a few simple steps before handing out a sizable chunk of change that you expect to be repaid:
Ask questions. You're assuming the risk, so you have every right to know just how the money will be put to use. If you're funding a new business, ask if there are other lenders, how much of the cost the borrowers are kicking in and if your loan can be secured with equipment or real estate. If the loan is personal, it would be worth knowing that the money will pay for a nursing home as opposed to, say, gambling debts.
Make sure you can afford it. Think twice before lending money you are counting on having down the road. A ruined relationship is bad; a ruined nest egg is a disaster. If you can afford to lose the money, consider making it a gift from the start.
Document the loan. This is critical. Put the agreement in writing. A business loan should include a formal business plan. Draw up a promissory note and a repayment schedule with penalties. This is when firms like Circle Lending can help. It charges from $200 for a personal loan to $800 for a mortgage, plus a monthly fee of $19. But you get bulletproof documentation for legal and tax purposes and billing and collection services too. It will also restructure the loan if necessary. Such flexibility is hard to find at a bank "and really keeps a loan on track," says Asheesh Advani, founder of Circle Lending, who adds that proper documentation cuts the default rate by more than half--to about 5%.
There are less eleemosynary reasons to chance a private loan. You can generally command a higher rate than you would get with a bank CD, even while offering the borrower a lower rate than would be available through a bank. Radena Stager, 28, borrowed $440,000 from her parents two years ago to purchase a home in Cupertino, Calif. She's paying a fixed rate of 4.9%, vs. the 5.9% market rate at the time. "I'm in more house than I could ever have afforded on my own," she says. Mom and Dad, meanwhile, are enjoying income above what was available in a bank CD.
The equation can work the other way around too--if parents are the ones who need cash. Maybe one of your kids has become a rock star or hedge-fund whiz. By setting up a privately funded reverse mortgage, in which your well-to-do child is the bank, you may be able to cut your loan expenses by more than 50% when you bypass the bank. Meanwhile, the house stays in the family. You also get the benefit of keeping order if you have more than one child. The one who supplements your retirement income through a reverse mortgage will have documented equity in your home, to be paid before your estate is settled.
If the income side of the equation appeals to you but you do not have a child or close friend you want to finance, consider some other private-loan options that have surfaced. At prosper com and zopa.com you get matched with borrowers who have been vetted through their credit reports. That's no guarantee they'll pay. Still, in some cases the borrowers are consolidating credit-card debt and agree to a rate of 10% or more.
You can even try to change the world by lending as little as $25 to a Third World entrepreneur through kiva.org If the loan goes bust and ends up a gift, at least it went to something worthwhile--kind of like that bad loan to your kids. *