The Pros and Cons of Lending Money to Friends and Family

Money can serve as a severe source of stress in interpersonal relations, causing friction and discomfort when there is disagreement. Though lending and borrowing among friends and relatives is not uncommon, it can also damage relationships if not handled wisely. Not surprisingly, there are both pros and cons for lending money to friends and family.

The benefits and disadvantages should be well understood and fully acknowledged prior to proceeding down this path. Read on for a discussion on how to make sure that any loans you are involved in do not end up causing discomfort at future family and social get-togethers.

Is It a Good Idea to Lend Money to Family?

Whether or not it is a good idea to lend money to family is almost besides the point. At some point in our lives, it is fairly likely that each one of us will be asked to help a friend or relative out with a financing need. It is therefore important to understand the implications of such a request.

First and foremost, make sure to be fully aware if you have the financial wherewithal to provide the funding that he or she is asking for. It is a big mistake to lend more than you can afford. If you would likely need the funds in question to cover your own costs, it is okay to say so and take a pass on making the loan.

Another important tip is to record the event. Many of us feel an inherent comfort level in dealing within own social circles, and this can make approaching friends and family easier than working with a commercial bank or lender. The informal nature of these relationships can create a scenario where documentation is sometimes overlooked. It is therefore absolutely vital to make sure that any transaction is written down with the specific terms of the loan, including the length of the repayment and interest rates. Beyond preventing future disagreement, this step has important tax-related repercussions (see below).

What are the Advantages of Lending Money to Family and Friends?

There are a couple of advantages of lending within your social circle.

For starters, providing financing to your family and friends can directly support your loved ones as they pursue their ambitions. You can help them earn a degree, purchase a home, or even start a business. We all want to be a positive influence in the lives of our loved ones, and providing financing is a tangible opportunity to do just that.

Second, because you are not a commercial lender, you have significant leeway to provide more comfortable terms and conditions. This can include longer repayment periods and lower (or non-existent) interest rates, two items that can lower the overall cost of the loan and make a world of difference for prospective borrowers.

In theory, you should have a fairly good sense of the reliability of your prospective counterparty, giving you a strong indication of whether they are a credible borrower who will indeed pay you back according to the terms of your arrangement. In this way, providing financing can be a way to earn a guaranteed return on your monies.

While individuals who agree to lend to their family and friends are usually not out to take advantage of them, even charging below-market interest will still allow you to lock in a given rate of return on your investment.

What are the Disadvantages of Giving Loans to Family and Friends?

The biggest disadvantage of lending to your relatives and friends is that you may not see this money again. While this is always a risk for lenders, throwing family and friends into the mix can add a toxic element to previously enjoyable and supportive relationships.

You should strenuously avoid letting guilt be the determining factor in your decision making. This is a big red flag, and can be the spark that ignites bad blood if the financing turns sour.

At the end of the day, the purpose of providing financing to your friends and family is to help someone. This needs to be done in a way that does not harm your own financial circumstances, or else you will be the one turning to others for assistance.

Before you offer financing, think about how you would feel if the loan never gets repaid, or if it takes place at a much slower rate than was agreed upon. Would you still be able to provide for yourself and your family, and achieve your goals? If the answer is anything other a resounding yes, think very long and hard about whether it is worthwhile for you to provide the loan.

Are There Tax Implications of Lending Money to Family and Friends?

There can be tax implications of providing a loan to family and friends, though this depends on the size and terms of the financing in question.

If the loan is $10,000 or less, the Internal Revenue Service will generally not pay attention. After all, lending a buddy $50 to go to a basketball game is not of much interest to the U.S. government.

You do not need to charge interest on loans valuing $10,000 or less in order for the financing to be considered a loan. However, if the loan is over $10,000 or is used for income-generating purposes, then the IRS will consider the monies earned via this loan as taxable income. Loans over this amount that are not interest-bearing will be considered a gift and taxed accordingly.

If it is indeed a loan, it is important to have this documented to legally demonstrate that this is not a gift. At a minimum, this should include a signed agreement with the loan amount, repayment schedule, and interest charged.

(The IRS also sets a minimum amount of interest that must be charged to be considered a loan. This is called the Applicable Federal Rate, and is published by the IRS on a monthly basis.)

If you are uncertain whether the financing is considered a loan or a gift, it is always a good idea to speak with a tax professional.

Conclusion: Should You Lend to Your Family and Friends?

It’s best practice to conduct a full due diligence on any potential investment, regardless if the destination is in the stock market or with a friend. Part of making an investment is understanding the role of risk, and your level of comfort in taking on this uncertainty.

In addition to the research you would perform for standard investments, do not neglect to consider how you would feel if the money were to be lost. This goes beyond the financial component, of course, and extends into the realm of personal relationships.

Only you can say how this loan will impact your financing and your feelings. Make sure to account for both when making your decision.

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