I received a message from a reader with the following request:

“I’d really like to see a blog post about the pitfalls and costs of lending friends/family money. Most loans to friends/family are interest free, and most borrowers and lenders don’t realize the costs to the lender (ie, the lender is paying for the privilege of being generous/kind). I’d love to see that broken down in two scenarios: (1) the lender has debt, and (2) the lender does not have debt but would be losing investment earnings on the money. Most loans to friends/family are small – $200 to $2000 range (based on my own unfortunate experience), and I’d love to see hard numbers on the actual cost of that over, say, a 6 month to 2 year period. I’d also like to see an “if you must do it”, advice for the conditions you should impose as the lender to protect yourself.”

Great question.

I think we’ve all done that – lent money to a friend or family member who failed to repay the debt, leaving us feeling frustrated and annoyed. Women in particular appear to be susceptible to what I call the Lending Problem – we always want to help out and we can’t say no even when we feel uncomfortable or aren’t really in a position to lend.

Here’s the question then: should we do it at all? And if so, when should we lend money, how should we go about it and what are the true costs of the loan?

After twenty five years in business, multiple professional partners and business deals that involved both friends and family, I have learned an important lesson: Treat everyone the same and treat all investments the same way with no exceptions to this rule.

It doesn’t matter if the request for money comes from your brother, aunt, cousin, best friend, a perfect stranger, a business colleague or the Pope – they should all receive the same level of due diligence.

Yes, that’s right, I used the words due diligence in the context of lending money to friends and family because that’s what you need to do for all requests that involve investments. A loan to a friend is an investment unless you’re giving the money away with no expectation of being repaid, in which case it’s a gift.

When a friend asks you for money, what they’re really asking for is an investment in them. They won’t view it that way, but the fact remains that by lending them money you’re buying into them.

I’ll address the cost of loans in a second but first I want to look at the factors that I consider when deciding whether or not to lend money. My business lends money in the form of second mortgages and the following are precisely the sorts of questions I ask myself every single time. If a friend or family member were to ask me for money, I’d take the same approach with them.

Do you have the cash for the investment/loan?

It seems pretty obvious: you can’t spend money you don’t have, right? Wrong. I see this all the time – people who have corrosive debt lending money to others. I have written multiple posts on the evils of credit card debt, but in case you’re new to my writing, when I talk about corrosive debt I mean any debt that sucks money out of your pocket without ever putting anything back. Think lines of credit, credit card debt, most car loans and so on. Credit cards are especially nasty because they will typically cost you 18% – 23% in interest on outstanding balances. I can’t think of a faster way to go broke other than burning your money. Seriously, 23%? That’s nuts! If you’re paying credit card interest, what are you doing thinking of lending money out? You’re paying a fortune for the cash you already owe! You are not in a position to lend money.

But Doris, you might say, don’t other people use borrowed funds? Sure, investors use borrowed money all the time and that’s great for buying assets that a) put money in your jeans and b) grow in value over time. Since most loans to family and friends are interest-free, they don’t earn a dime. Why would you pay to lend money? You’re just putting yourself at risk for someone else.

Is that necessary? No.

Is it wise? Definitely not. It may be well-intentioned but it is not wise.

More objections: “But Doris, that’s not generous! Surely I have an obligation to help out.” Look, if you really want to make a difference, get your own financial house in order and then go help a pile of people. Seriously, do whatever it takes to get rid of corrosive debt and then help a heap of people. I’m not saying that you have to pay off your mortgage first, just the nasty, unproductive stuff.

If a friend asks for money and you’re in the midst of dealing with your own debts, simply say, “I’d love to help out but I just can’t right now.” Then take the money you would have given to them and pay down your credit cards and keep them down! You get the picture.

If your friend or family member tries to guilt you out, run away, don’t walk. No guilt. Do not accept people in your life who use guilt to serve their own interests.

What are the circumstances and is this a self-inflicted injury?

Why is the person asking for money? Is there a legitimate reason? You may not understand all of the factors that went into a person’s situation, but you nonetheless have to decide if you think there’s a solid reason for the need for money. Here are a few questions to ask:

• Is this a one-off occurrence or are they the kind of person who seems to burn through cash? If it’s the latter, what makes you think they’ll change their ways and pay you back? They won’t. No, they really won’t, don’t kid yourself.
• In the same vein, have they asked for money before? Why are they still asking for money? If they keep making poor decisions, is that your problem? No, it’s not. It’s unfortunate, but it’s not your issue to solve. They need to figure it out.
• If they are in a bad situation, is it something beyond their control (e.g. illness or job loss) or did they do it to themselves (e.g. spent the money frivolously and now can’t afford to pay the rent)?

This is a sensitive area for me because when I lost my first husband I was in a financial mess that left me wondering how on earth I would survive. I managed to pay for the funeral and get myself back on track courtesy of the generosity of friends and perfect strangers. I understand firsthand what it’s like to be in a very difficult situation.

Some people genuinely need help and will repay the loan. The irony is that they’re not usually the ones asking for a loan from friends though.

What is the character and history of the borrower?

For any investment or loan, you have to evaluate the character of the person requesting the funds. Ask yourself, what is the likelihood that they’ll repay? Are they the kind of person who is constantly making excuses as to why crap befalls them or do they generally take ownership of failures?

If their track record is dicey or they’re always blaming someone else for their misfortune, then why would you give them money? You are not responsible for their choices and their situation, they are. You may feel compelled to help out a friend who is a good person but if they’ve created a mess for themselves by their own doing, that’s not your issue.

Don’t take on their mess or play the role of an enabler. If they’re not accountable for their life and you give them money, don’t be shocked if they are in exactly the same situation as soon as they’ve burned through your cash. And they will. You won’t really have helped them and you’ll be worse off. Lose-lose.

What are the costs involved in this loan?

This is key. If you’ve decided to lend money interest-free when you have corrosive debt, then you are paying a hefty price for the loan courtesy of the carrying costs of the debt. For every dollar that you do not pay down on your credit card, for example, you pay roughly 18% interest. Let’s assume that you’re only making the minimum payment on your card and that you owe precisely the amount that you have lent out. Here’s what it would cost you using the two dollar amounts mentioned by the reader:

• $500 balance on the card paid off in minimum payments at 18% interest = $198.36 in interest charges alone, not to mention that it will take just under four years to pay off the principal amount owed. Four years!!!
• $2,000 balance on the card paid off in minimum payments at 18% = $798.44 in interest charges alone and once again it will take just under four years to pay off the principal amount owed.

You can use this calculator or any other freebie found online to play with these numbers. Bottom line: it’s financially damaging to lend money when you have credit card debt.

If however you have no unproductive debt and you’re using available cash for the loan, then you need to consider the opportunity cost. If you place your money in an index fund, for example, then you will average returns of roughly 8% per year (it varies depending on the fund and the year, but long-term returns fall in this range, give or take a percentage point). Therefore, if you lend out $500 over a two year period, then you will miss out on $83 in compounded returns at 8%. (To calculate this simply use any online ROI calculator.) If you lend out $2,000 over two years, then you will miss out on $333.

The value of helping out a friend may be more important to you but you should nonetheless be aware of the cost.

What are the consequences if the loan goes south?

Ah, the unsexy down side. From my experience people are quick to see the upside of investments but not so keen to entertain the flip side.

What if it doesn’t work out? What do you lose? Will the loss of the cash hurt you? Will the friction between you and your friend or family member be worth it?

What if the relationship deteriorates completely as a result, how will that affect you? Thanksgiving dinner could be awkward if you’re seriously pissed off at the guy across the table.

In my Rent to Own business I have stopped accepting friends and family members as investors for real estate deals because I don’t want to risk those relationships. Thankfully, in more than ten years of investing in real estate I have only had one deal go south, but the risk exists in every deal and I don’t want the additional stress of worrying about family dynamics.

When you lend money, you need to be very clear on what the impact will be in the event that the borrower fails to honour the commitment.

And by the way, whose problem is it if they fail? Yours.

Whose responsibility is it if the arrangement goes south? Also yours.

If you lend money you must take responsibility for the results. To be clear, it’s not your fault if they don’t repay but it is your responsibility. Don’t complain about the borrower; learn from the experience. Unless someone put a gun to your head the decision to lend out the cash was yours. Be accountable and next time choose a different path. You might also have to make some hard choices about a “friend”.

Put it in writing

If you decide that you’re in a good position to lend money and the borrower appears to be trustworthy, here’s my advice: never, ever lend money without creating a written agreement. I don’t care if the deal is with the Pope who swears to God that he’ll repay. Great, put it in writing. Include all the terms – the amount borrowed, to whom, from whom, the date on which you’ll give out the funds, the terms under which the money is being lent (i.e. the interest rate if any) and the terms of the repayment (i.e. how much, how many payments, what date), etc. Put it all down in writing and then have all parties sign and date it. If they are to begin repaying in six months, then have them write you post-dated cheques. I personally would not accept promises of e-transfers. A bird in the hand… as the saying goes.

Think of it this way: Would you lend money to a stranger without a contract of some form which includes repayment details? Not a chance. Do the same with family and friends. A written contract prevents memory lapses and ensures that everyone is on the same page regarding the details. Black and white is your friend.

A written contract also makes it clear that this is a loan and repayment is expected.

Remember that the best way to retain friendships in such circumstances is to dot the “i’s” and cross the “t’s”. It’s not anal, it’s good practice.

If someone accuses you of being ungenerous, remind them that loans are not donations. You can be generous with charitable gifts, but loans should always be undertaken with a more business-like approach. Don’t confuse the two.

A word to borrowers 

Pay back your loans. Every time. It’s not cool to stiff friends or family who have put their trust in you. You owe it to them and to yourself to honour your obligations. Here’s the thing: you will not succeed at anything until you honour commitments and take responsibility for your actions. No excuses, not “buts”, no “you don’t understand” – it’s all baloney and everyone knows it. Figure it out and pay back what you owe.

Thanks again to my reader for a great, thought-provoking question. If you have a different perspective, please comment below. If you have a question you’d like me to tackle, fire away.

Until next time, Survive, Thrive and Grow.