Many of us have friends or relatives in our lives who are struggling financially. Perhaps they’ve made some poor financial decisions in the past, lost their job, went “all in” on a failed business opportunity, or they’re simply not earning enough to pay their living expenses and other obligations like student-loan balances. And there may come a time when they ask you for help.
Lending money or co-signing on a loan can be a risky endeavor for you, though. First and foremost, there is the risk that you won’t be paid back (or that the payments on a loan that you co-signed won’t be made). Not only can this result in a loss of the funds you loaned (and damage your credit score), it can make things awkward between you and the friend or relative you’re helping.
So how can you best go about co-signing on a loan or lending money to a friend or loved one in a way that increases the chances of actually getting paid back?
The Pros and Cons of Lending Money Outright
Seeing a loved one in a difficult financial situation can be hard, and many people end up letting their emotions take over and do whatever they can to help. But that isn’t always the best solution.
Although loaning the needed funds could enable the borrower to purchase a new business, avoid late fees on their bills, learn fiscal responsibility, or obtain a home or apartment, there can also be several drawbacks to consider, such as:
• Resentment or hard feelings if the person does not pay you back (or even if they’re consistently late with their payments).
• Overextension of your own financial situation. For instance, if you have an emergency, you may not have enough money available for your needs.
How Co-signing a Loan Can Impact Your Credit
Even if you don’t actually lend money to your friend or family member, they could still ask you to co-sign on a loan that they are getting somewhere else. You need to be careful here, though, because doing so could have an impact on your own credit score.
For instance, being a co-signer in and of itself won’t necessarily harm your credit. But, if the borrower is late with their payments, or misses payments altogether, you could see your credit score go down.
In fact, even if the loan payments are made on time, being a co-signer could still affect your amount of credit utilization, and in turn make it more difficult for you to obtain a loan in the future.
Graciously Saying No
If you are unable or unwilling to lend money or co-sign on a loan, it is important that you politely tell the potential borrower no as soon as you can. That can help to relieve any pressure on you, as well as to let the other person find a better fit for obtaining the funds they need.
Being concise, yet firm, is usually the best route to take. For example, you could tell them, “I would love to help you, but as a general rule, I do not lend money.” While this may be disappointing to the other individual, it is much better to decline the request than to move forward with an unpleasant situation or to make promises that you cannot keep.
Depending on the situation, you may be able to help out in ways other than loaning money. For instance, you could assist your friend or family member with earning additional income by writing a letter of recommendation to potential employers or referring them to companies that you know are hiring. Likewise, you could help them to find and list unneeded items on eBay or craigslist to earn some quick extra cash.
How to Safely Lend a Helping Hand
While many financial professionals advise against loaning money to friends and family, the reality is that you could make the loan because you don’t want to see them struggle. With that in mind, here are some important safeguards to consider:
• Interest – Although most people are happy to help a loved one and would consider doing so for free, it is important that you charge interest on the loan. One reason for this is because you’re losing out on other potential interest-generating financial opportunities. In addition, the IRS requires that at least some amount of interest be charged, even on private loans. This is known as the Applicable Federal Rate, or AFR. Each month the IRS publishes a set of interest rates that it considers to be the minimum market rate for loans. You need to be sure that the interest rate you charge is equal to or more than the AFR rate. (Charging any less than the AFR rate could cause you to incur taxes on the interest income you receive). You can find more information on the Applicable Federal Rates by going to https://apps.irs.gov/app/picklist/list/federalRates.html.
• Collateral – One way to help ensure that you are repaid is to ask the borrower for some collateral. This could include something of value, such as a family heirloom, that you retain until the loan has been paid in full. If the borrower ends up defaulting, you are protected financially by selling the item. Make sure you have your agreement in writing by getting it notarized and filed where necessary.
• Legal Documentation – As with any contract such as a car loan or an apartment lease, you need to document the loan in writing. This includes the amount of the loan and the interest rate, the monthly payment, and how many payments in total are required to pay off the loan. You should also consider adding the amount of a late fee due if the monthly payments are not made on time. Both you and the borrower should sign the paperwork and retain a copy for reference.
Having the guidance of a legal and financial advisor can help ensure that you are properly going about the process and not leaving anything out. These professionals may also be able to guide the loved one you are helping, so that person can make good financial decisions going forward.
This article appears in the October 2019 edition of OutSmart magazine.