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5 Things to Consider Before Lending Money to Friends and Family

5 Things to Consider Before Lending Money to Friends and Family
Image credit: Business Emerge

"Neither a borrower nor a lender be," Polonius advises in Hamlet, "for loan oft loses both itself and friend." Shakespeare was a smart man.

When a friend or family member asks to borrow money, think about why they're asking you and not someone else. They may see lots of money coming into your business, payroll being met, maybe your nice house and car. What they don't see is the credit line that keeps your doors open or how thin your profit margins really are.

Cosigner Beware
Cosigning on a friend or family member's loan may sound like a better idea than loaning money outright, but it can end up worse for you if something goes bad. As a cosigner, you're legally obligated for the debt. If the debtor skips town, you'll be stuck with the payments, a black mark on your credit and a broken friendship.

Still, that hasn't stopped many business owners from learning the hard way that family, friends and finances don't always mix. I know a couple that borrowed $20,000 from a family member. Ostensibly, this money was to save their home from foreclosure. But instead, they bought iPhones, the woman had cosmetic surgery and the home still went into foreclosure. They never repaid the loan, and they get resentful when asked about it.

Of course, not all loans to family and friends end in disaster, but the potential for trouble is so great that you should think twice before saying yes. To save yourself a lot of grief, consider in advance how you'd handle any problems; in particular, ask yourself what would happen if the borrower never repaid the loan. How would it affect your finances--and your relationship?

Some people simply decide they'll never make personal loans: If asked, they say, "Sorry, but it's my policy never to lend money."

That said, if you feel you must extend credit to a family member or friend, follow these rules. You'll be glad you did.

1. Discuss other options. Are there other ways to help? Money isn't usually the only solution.

2. Lend only the amount you can afford to lose. You may never see the money again, so don't put your own financial well-being on the line for your cousin Joe.

3. Be clear about your expectations. Draw up a payment plan. You can use the online calculator at Bankrate.com to create a loan schedule. And discuss what will happen if something goes wrong.

4.Get it in writing. At LawDepot.com, you can fill out a web form, and for $15 you get a complete promissory note. There's also a free sample template at ExpertLaw.com.

5. Deal with problems right away. You may feel you're being kind by not sending a reminder that the payment is 30 days past due, but you're just setting yourself up for trouble. Let the borrower know you're keeping track.

Here's another idea: If you can afford it (and if it seems appropriate), consider giving the money instead. That way there's no ickiness on either side. If you get paid back, great; if not, you can feel good about helping out a friend in need.

J.D. Roth is the founder and editor of the personal finance blog getrichslowly.org and the author of Your Money: The Missing Manual.

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This article was originally published in the October 2012 print edition of Entrepreneur with the headline: How to Be a Loan Star.

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