Helping friends or family shouldn’t mean hurting your finances
Let’s face it: Money is tight for many people. And if you have loved ones in your life who are struggling financially, you may feel inclined to help them.
If you do, proceed with caution. According to a 2022 CreditCards.com survey, 42 percent of people who lent money did not get repaid, and about half of Baby Boomers and Gen Xers said they got burned in such transactions.
“One of the most common mistakes people make when lending money to family and friends is expecting to get it back,” says Nate Towers, director at Five Pathways Financial, a retirement planning firm in Phoenix. “If you’re going to lend money, you should assume that you might not be repaid. If you’re OK with that, then go ahead, but if not, you need to take steps to protect both parties involved.”
Are you considering loaning money to a loved one? Heed these dos and don’ts to protect yourself.
Do understand how it could impact your relationship
Before you choose to loan money to a friend or family member, think about the potential repercussions it could have on your relationship with them. According to the CreditCards.com survey, more than a quarter of people who lent money said it damaged their relationship with the borrower.
“Ask yourself what will happen if the loan isn’t repaid,” says Matthew Argyle, a certified financial planner and principal at Encore Retirement Planning in South Jordan, Utah. “Can you sacrifice the funds without sacrificing the relationship? If they fail to repay, will you sue them? Will conflict and resentment ruin the relationship?” Bottom line: weigh the risks before opening up your wallet to a close friend or relative.
Don’t lend money you don’t have
You should also be careful how much cash you loan someone. While it might be nice to help your loved one cover the entire cost of whatever expense they’re facing, limiting the loan to what you can reasonably afford is important.
“This is one of those situations where you need to ask yourself, ‘If I don’t get paid back, will I be OK?’ ” Towers says. “Be honest with your answer. If you lost 100 percent of what you’re lending right now, could you handle it? Would it affect your financial stability in the long run?”
Moreover, you shouldn’t tap into your emergency fund to loan money; reserve those funds for a rainy day of your own. And if you decide to use some of your retirement savings to help out a loved one, make sure it won’t throw your long-term plans off track.
“You should always prioritize your own financial security before lending to family, no matter how much you want to help,” Towers says. “If lending will jeopardize your retirement, it’s simply not worth the risk. Think of it like being on an airplane: They always tell you to put your oxygen mask on first before helping others. It’s sound advice in this situation.”
Another thing to consider: If you have to pay any penalties for the funds you loan out — early withdrawal fees on a certificate of deposit (CD) or individual retirement account (IRA), for example — consider factoring those costs into the loan amount.
Do get it in writing
Before you give a loved one money, get the terms and conditions of the loan down on paper. While you might trust the person to keep their word, having an agreement in writing can ensure there’s a legal obligation to do so.
You could have an attorney craft a loan agreement, or create one using an online legal resource such as LawDepot, Nolo or Rocket Lawyer. A promissory note — a document in which the borrower promises to repay the other party a specified amount of money — will often suffice in these situations, Argyle says.
The contract “should include key details, like whether you’ll charge interest, the repayment schedule, due dates and any consequences if the loan isn’t repaid,” Towers says. “You might even consider having another family member sign as a witness. For an added layer of legitimacy, you can also have the contract notarized at your local bank.”
A signed agreement reduces the potential for disputes and “preserves goodwill,” Argyle says. It’s also important tax-wise if the borrower fails to repay the loan.
“If you aren’t repaid, you may be able to claim a bad debt deduction, but only if you can prove the loan was legitimate,” Towers says. The loan contract provides this evidence.
Don’t forget about the IRS
When planning your loan, make sure you take into account the potential tax implications. These will depend on where you source the money, financial and legal professionals say. “If you have to pull it from your IRA, you are incurring [income] taxes to get the money,” says Pat Simasko, an elder law and estate planning attorney at Simasko Law Offices in Mount Clemens, Michigan. (This is only true for traditional IRAs, withdrawals from which are taxable; with Roth IRAs, you pay income taxes on these before putting money in the account.)
Generally, money you withdraw from a 401(k) is also taxed at your ordinary income tax rate (unless you’re using a 401(k) loan). And “if you are selling stock, there might be capital gains taxes,” Simasko says. “It all adds up and should be included in the amount they have to repay you.”
If you loan out more than $10,000, you’ll need to charge interest on the loan, too, Argyle says. The IRS sets the applicable interest rates monthly. “That interest counts as taxable income, and you’ll need to report it on your tax return,” Towers says. “Depending on the size of the loan, this could push you into a higher tax bracket.”
Do consider consulting experts
Ultimately, the best way to protect yourself is to consult an attorney when setting up your loan. You could get guidance from a tax adviser and a retirement planner as well.
“Obtaining professional advice on the front end helps address any potential violations of the law,” says Troy A. Young, a certified financial planner and founder of Destiny Financial Group in Atlanta. “It is always easier to prepare than it is to repair.”
Can’t lend money? Offer other ways to help
If you determine you’re not in a position to loan a loved one money or the relationship just isn’t worth the risk, you may need to politely decline.
“You can soften the message by offering emotional support like, ‘I wish I could help, but I’m not able to lend you money right now. If there’s anything else I can do to support you, let me know,’ ” Argyle says. “You can also redirect them with a line like, ‘I’m not in a position to lend money, but I can help you look into other options.’ ” If your finances are tight, offering to help with childcare, for example, could be a way to provide meaningful assistance and help your loved one save money.
In some cases, you might consider cosigning a loan with your loved one if it would help them qualify for one. But be careful: If they fail to make payments, you would need to step in and take over. For this reason, make sure “you can shoulder the full payment without hardship” before co-signing, Argyle says.
https://www.aarp.org/money/personal-finance/lending-money-to-loved-ones/