If you are considering lending money to friends or family members, this article discusses what you should consider, and how you can increase the likelihood of having your loan repaid.
Should you mix friends or family and finances?
Private loans between family members and friends are a convenient, flexible and cheap alternative to using commercial loan organisations such as banks or pay-day lenders.
Many people in need of a loan will first approach relatives or friends who appear to have money to spare, especially if the borrower does not have a good credit history, or is just starting out financially.
The lender may have good reasons for making the loan which are not financial, for example parents may lend their children money for university or to help them buy their first home.
Consequences of loaning
Whatever the motivations are for such private loans it is important to be aware of the potential ramifications of introducing financial matters into a personal relationship.
For example, the lender might appear to gain power over the borrower, or siblings who have not received similar loans could become jealous of those who have. Even worse, what if the borrower can't or won't pay back the loan?
To avoid such damaging implications (to relationships or finances) it's a good idea to first consider carefully whether to make the loan, and then formalise the terms of the loan and repayment arrangements in a written agreement.
Can you afford it?
First ask yourself whether you can afford to make the loan.
Consider possible changes in your circumstances – would lending the money leave you enough of a buffer?
Think carefully about the consequences to your personal relationship with the borrower. Of course there are implications to denying the loan as well, but at the end of the day it is your money and your decision. If you have real fears about the possible consequences of the loan these will outweigh the (usually temporary) bad feelings resulting from refusing to lend.
Can they afford it?
Next you should think about whether the borrower can afford the loan. Will they be able to repay it within a time-frame that you are happy with?
Sometimes in these situations the 'borrower' is really looking for a gift and has no real intention of repaying the money. This may not even be a conscious decision on their part but it is essential to be clear on this. You might even decide that you want to make a gift (perhaps of a smaller amount) avoid bad feeling and potential complications associated with a loan – but both parties should be aware of the decision to make a gift and why.
Of course, you will want to know why they want the loan, and this could affect your decision to give it. If you can see they need the cash for a good reason but don't trust their ability to manage the money you lend them, why not offer to pay it directly to where it is needed?
On the other hand they may be perfectly able to approach a financial institution for the loan but are looking for a cheaper alternative – it's up to you whether you want to oblige.
Using a written loan agreement
If, after addressing the above questions you still want to make the loan, you will probably have thought of a number of conditions in the process. Hence it is clear to see why a written agreement is a good idea. By setting out your conditions in writing, both you and the borrower can agree with full awareness of those terms and the repayment.
It may seem quite hard-nosed to insist on a written agreement when dealing with friends or family, but it is the best way to separate your personal relationship from a financial relationship, and to acknowledge that personal ties should not influence or be influenced by financial responsibilities. If there is reluctance to use such an agreement then complications exist already!
An agreement usually sets out the terms of the loan, in particular the amount to be loaned, the interest rate, the dates and duration of the loan, the frequency and value of repayments, any collateral used to secure the loan and under what conditions you will be free to sell or take possession of the collateral. You can find out what terms you should include in a loan agreement.
Collateral or security
It may be a good idea to secure the loan by obtaining collateral, that is, taking something from the borrower which you can sell if they fail to repay the loan.
Ideally it should be something which would cover the value of the loan, but if there is nothing of sufficient value, choose something of personal value to the borrower which will give them incentive to stick to the terms. You should include this collateral and what can be done with it in the terms of the agreement.
Most people who lend to family or friends do not charge interest. However, you should consider whether you will lose significant earnings on the money during the period. It could be a good idea to charge at least the same interest that you would earn on the money if it stayed in your possession. Charging interest will also discourage the borrower from viewing the loan as a gift.
Simple interest calculations are usually the best, and the simplest is a fixed amount over the term of the loan, for example, if someone borrows £4,000 from you, you may charge £200 of interest to be paid back in equal instalments over 10 months (they pay £420 a month for 10 months for borrowing £4,000).
Remember that if you do charge interest it is taxable income in the eyes of Her Majesty's Revenue and Customs and must be declared as such.
Once you've drawn up the agreement, both parties should sign it in the presence of independent witnesses and each keep a copy. Now you can transfer the money to the borrower – do this in such a way that there is an indisputable record of the transfer, for example by direct bank transfer or cheque.
Once the money has been transferred, the agreement takes effect, and now the important thing is to keep records - of the initial transfer, and when and how much you have been repaid. Repayment by standing order is preferable.
Taking action if they fail to repay
If the borrower does not stick to the terms of the agreement, it is your choice as to how to proceed. The first step is to talk to them – establish what the problem is and whether you can resolve it between you. You may wish to vary the terms in the initial agreement (to give them more time to repay, for example). In this case you must both sign the updated agreement with witnesses present.
If the agreement has been breached and you decide you want to get your money back, you can take legal action. For amounts less than £5,000 you should first approach the Small Claims Court or Money Claim Online. For larger amounts you will need to seek legal advice.
You can find a template loan agreement specifically for lending to friends and family in our library. It balances the need to be formal enough so that the borrower knows the loan is not charity with simple language so that the agreement does not seem 'over the top' in the situation where the lender and the borrower know each other well.
Our unsecured loan agreement can be used for more formal arrangements where the borrower does not give any security or collateral, while Loan agreement: person to person; secured by guarantee includes the option to bring in a third party guarantor to make sure the loan is repaid.
You might like to read our article on the how the breakdown of a personal relationship can affect repayment of debt.