Why do people borrow money from family and friends?
Imagine you’re in a tight spot financially, and need some additional cash to get your house in order. Your credit isn’t great, and every reputable lender you contact declines to offer you a loan. You feel stuck – until your parents offer to lend you the money. You accept, and they write you a check.
This story happens everyday all across the country, and it can go one of two ways.
In the first scenario, you draw up a legal contract with your parents and offer a small interest payment to thank them. You always make your payments on time, and frequently communicate about the loan and your financial status. Eventually you pay off the loan completely, and the trust you’ve built over the lifetime of the loan strengthens your relationship.
In the second scenario, the loan is agreed to on vague terms and with little communication. Your parents make no mention of paying interest, and you don’t either. You try to make your payments on time, but it seems like you’re always coming up short at the end of the month. Your parents make passive aggressive comments about your delinquency at first, but eventually they stop mentioning the loan. You feel bad, but eventually stop making payments entirely. Your relationship deteriorates over the lifetime of the loan, and there’s always an awkward tension when you spend time around them.
It’s an easy process
If you’ve applied for any type of loan before, you know how frustrating the process can be, even if you have a great credit. Borrowing from family or friends is much simpler, which means you’ll get your money faster. It also won’t go on your credit report, so there will be no official record of the loan unless you sign a contract. Even with a contract, it won’t affect your credit score.
There’s no interest
One reason why many people try to borrow from their family and friends is to avoid paying huge interest fees. Credit cards have a 15% APR, while personal loans can also be in the double digits. But if you borrow from someone you know, they likely won’t charge you interest.
However, it’s best to give them some form of interest when you make your payments, like $50 extra or an offer to babysit their kids for a few nights. If you truly can’t afford to pay extra, just make your payments on time and be grateful.
It might be your only option
If you’re starting out in life, getting a loan can be impossible, especially if it’s for a new business. Getting seed money from your family could be the difference between living your dream or scrimping for the next few years.
Family loans are also good if you’ve maxed out your student loans, need to buy a car ASAP or find a great deal on a house. They’re also popular if you are struggling with bills and don’t want to resort to a payday or title loan.
It could be illegal
It used to be common that parents would lend their children the down payment for their new home and no one would disclose that loan on their mortgage application. Nowadays lenders require that applicants list all of their debts, even if it’s to a family member or friend.
Failure to do is considered fraud and could result in your application being denied. Before you accept your parent’s help with a down payment, make sure you’ll still be eligible to take out a loan if you include their money in your list of liabilities.
Most mortgage lenders require a debt-to-income ratio of 43% or less because they want to know you can afford to pay the mortgage by yourself. If your family loan puts you over the top, then you likely won’t qualify.
It could change your relationship
Unfortunately, many people avoid lending to their friends or family members because they’re worried the transaction will ruin or damage their relationship. What happens if you can’t pay them back? Or if they lose their jobs and need you to repay them faster than you initially agreed to? There’s no way to predict how someone will feel about lending you money months after the deed is done.
True life story
Here’s a true story of how a situation like this can cause a relationship to deteriorate. The names have been changed to protect their privacy:
Cynthia Johnson’s sister called her a few months ago to ask if she could borrow some money for her kid’s summer camp and daycare. Cynthia agreed and said not to worry about paying her back. But then she learned the truth about her sister spends her money.
“The real issue I had was that I found out my sister has been making pretty good money as a trauma RN, her ex had been paying her most of the child support and the best part, she got breast implants,” she said.
Someone who gets plastic surgery doesn’t seem like the type of person desperate for money. Cynthia said her sister eventually messaged her and asked if she could send her a check for the amount she borrowed. Even though Cynthia got her money back, she said the whole experience has changed their relationship.
“I have six siblings and she’s the one I felt closest to,” she said. “She’s changed a lot in the last year with her divorce and has started seeming to feel more entitled – using her horrible marriage as a way to ask people for things. I probably won’t be giving her money again in the future. I don’t trust her.”
When you’re borrowing money from someone, you’re inviting them to critique how you live and what you spend money on. It’s not fair to ask your best friend for a $1,000 loan and then go on a vacation to New York for a week.
How to handle it
Have a contract
Shanah Bell borrowed money from her father a few times – once to pay for a car and another time when she was getting divorced and needed money for a lawyer.
“My dad and I worked out a contract, had it notarized and I paid him back earlier than our agreed time limits,” she said.
A professional contract with set terms and conditions can solidify the loan so that neither party considers it a gift or is surprised when it’s not paid back in full. When you set hard and fast rules, there’s little room for ambiguity or misunderstanding.
Bell said she has promised each of her children she will lend them money for a vehicle when they’re ready to own a car, but don’t have the money for it. Like her father before her, she’ll have them sign a contract, but will not charge them interest.
“I think this has taught us all a good lesson with regards to borrowing money and paying it back in a timely manner, without the interest repercussions,” she said.
When you’ve lent a significant amount of money that requires more than a one-time lump payment, it can be easy to forget how much has been repaid. Each party should track the loan, whether it’s with a shared Google spreadsheet or an email exchange.
Apps to manage your money like Splitwise, PayPal or Venmo also work because it’s easy to see who paid what and when.
Tracking payments protects both parties from assuming someone has skipped a payment or that the other person didn’t acknowledge the money you sent them.
Doug Nordman of The Military Guide said he was surprised by how much work it is tracking payments, especially the interest component. Because the loan issuer receives interest on the loan, they have to pay excise tax, state income tax and federal income tax on the interest. While he’s glad he was able to help his family members, he’s not happy about how much extra work it’s been.
The bottom line
There’s no clear answer to the question of whether or not you should borrow from family and friends. The only undeniable truth is this: if you don’t approach the situation carefully, it could have dire consequences for your relationship.
On one hand, a loan between friends or family is going to be a smoother, simpler debt vehicle than borrowing from a bank. It can also help down-on-their-luck people who don’t qualify for a loan to pull themselves out of a hole. On the other hand it’s so easy for something to go wrong, changing your relationship and making things awkward – potentially forever.
If you’re going to take the plunge, remember to draw up a contract. Communicate clearly about the loan, and make sure both parties participate in tracking the status of the loan.
Remember, this isn’t a detached relationship between a bank and a customer – the consequences for both parties are emotional as well as financial.