Be Careful When making Personal Loans 6/17/07
Stewart H. Welch III, CFP, AEP
Founder, The Welch Group, LLC
Be Careful When making Personal Loans
“Be Careful When Making Personal Loans”
Having been a financial advisor for over thirty years, I’ve seen just about every imaginable financial twist and turn. Requests for a loan from a family member or friend are one situation that comes up all too often. Inevitably, these encounters are tricky because someone is often left unhappy. There is little upside opportunity but lots of downside risk. Here are the key considerations to weigh before you make a loan:
Your relationship. In most cases, the friend or family member is coming to you because conventional lending options are not available. The person has probably already tried to get money from a bank, maxed out credit cards and has minimal equity in his or her home. In other words, you have become their lender of last resort, so make sure to get a guarantor for your loan. All of this significantly increases the likelihood that the person will either make late payments or default on your loan. If this happens, you’ll find yourself in the awkward position of trying to collect money from someone you care deeply about. In my experience, the dynamics will always lead to a change in the nature of your relationship with this friend or family member. Almost always, the relationship will suffer. Furthermore, loans to one family member can cause resentment and feelings of preferential treatment by other family members. Sometimes it is best to orient your family member or friend towards a loan service as they are the best resource for short term loans.
Formalize the loan. If you do decide to make the loan, you should formalize it with a written agreement. By using a written agreement, your message is that this is a business arrangement separate from your personal relationship. To view a sample loan agreement, go to the Resource Center at www.welchgroup.com and click on ‘Consumer Loan Form’. I recommend that you use an attorney to draft the agreement to make certain it complies with state laws.
Collateralize the loan. From a psychological perspective, the borrower will feel a higher level of commitment to repayment if he or she has assets put up as collateral for the loan. Granted, the collateral may not be worth much and, in the event of a default, you may be unwilling to collect the collateral, but it does serve to further formalize the business nature of the arrangement. Collateral can be anything of value such as a second or third mortgage on the borrower’s home, car or other assets. This has the added advantage of providing you some protection should the friend or family member later file for bankruptcy as it will place you in the creditor line-up.
One additional word of caution. Often, a friend or family member will ask that you simply co-sign a loan being offered by a bank or other financial institution. On the surface, this seems much less of a commitment than making a direct loan. However, this is not the case. If the borrower fails to make timely payments or defaults on the loan, you will quickly find yourself in the bank’s crosshairs. The result: your credit history could be damaged; you could be liable for repayment of the entire loan; and you could owe gift taxes based on the amount of the loan.
As you can see, a loan with no credit check to family members and friends are ripe with pitfalls and you should think long and hard before entering into one.