If you have money or people suspect you have money, you will eventually have someone ask you for a loan. Most likely, that person will be someone you both know well and care about. Emotionally you may have a strong desire to help, but should you? After forty-something years of watching this scenario play out hundreds of times, my best advice is, “No,” for the following reasons:
- Lending money to someone you know well and care about almost always changes the nature of the relationship. The lender becomes a master-of-sorts, and the borrower becomes more subservient…it’s just the nature of the lender-borrower relationship.
- The risk of losing some or all your money is relatively high. There’s a reason the person cannot borrow money through traditional channels. Lending institutions are generally very good at assessing risk, and if they are unwilling to make a loan, there is usually a good reason.
- There are tax consequences of making loans. The IRS ‘imputes’ a minimum interest income on loans, even if you don’t charge interest. It must be reported and taxes on that income must be paid.
In a recent survey by Bankrate.com, nearly one-half of those who loaned money to a family member or friend ended with a negative outcome. Thirty-seven percent lost,” while 21 percent stated that the relationship was damaged.
Is it OK to co-sign a loan?
Co-signing a loan makes you a lender, one-step-removed…sort of like being a stepdad or stepmom. If they default, the lender will be looking to you to take the borrower’s place. If you are called upon to repay the loan, you will have technically made a gift to the borrower and may need to file a gift tax return. You also risk damage to your credit score, so I’d advise against becoming a cosigner of a loan for someone else. As a co-signer, your ability to obtain credit may also become more complicated because you’d be required to disclose to a potential lender or credit card company that you are a co-signer of a loan and that loan amount counts as if you owed the money yourself.
If you do decide to make a loan, be sure to document it with a loan agreement. This ‘formalizes’ the transaction and takes it out of the casual ‘friends and family handshake’ category and moves it to a business relationship.
My last piece of advice is, “Never lend any money you cannot afford to lose.”
Follow The Welch Group every Tuesday morning on WBRC Fox 6 for the Money Tuesday segment.
FOX 6 TALKING POINTS
Don’t Lend Money to Family & Friends
- Loans to family and friends change the relationship
- Risk of losing your money is very high
- There are tax consequences
Cosigning a loan also has risks
- They default, you take their place
- Puts your credit score at risk
- Potentially limits your ability to obtain credit
Stewart H. Welch, III, CFP, AEP, is the founder of THE WELCH GROUP, LLC, which specializes in providing fee-only investment management and financial advice to families throughout the United States. He is the author or co-author of six books, including J.K. Lasser’s New Rules for Estate, Retirement and Tax Planning- 6th Edition (John Wiley & Sons, Inc.); THINK Like a Self-Made Millionaire; and 100 Tips for Creating a Champagne Retirement on a Shoestring Budget. More information about The Welch Group and important Disclosures can be found on our website. Investing in securities involves the risk of loss. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy will be profitable or equal any historical performance level(s). Consult your financial advisor before acting on comments in this article.