It is part of the African American spirit to help our friends and family who are in need. In this economy, that often means loaning money to someone you care about. If you’re not careful, however, you could also be creating a difficult situation for yourself, both financially and personally.
“I’ve found that lending money to people I’m close to can make the relationship feel awkward,” says Genma Stringer Holmes, an entrepreneur who owns Holmes Pest Control in Hermitage, Tennessee. “Sometimes it loses a little of its innocence, especially if there are problems with one person paying the other person back.”
On top of that, you as the lender could end up giving more than you have to spare. “Only lend money that you can afford to give away,” says Charlotte Stallings, a public speaker whose specialty is personal finance. Before lending any funds, ask yourself: If this money isn’t paid back, will it hurt my financial situation? If the answer is yes, you’re not in a position to lend it.
If you are fortunate enough to have money to give, experts say it’s best to keep a professional mindset. Document everything, offer fair terms, and try to focus on the relationship more than the money.
Write it down
“If you decide to make a loan to a friend or family member, ensure that you have a loan agreement that lists all the terms and conditions, such as the amount that’s being loaned, the interest rate, and the terms of payment,” says Frederick E. Davis, Jr., tax partner with Mitchell & Titus, an accounting, audit, business advisory and tax firm based in New York. With a written loan agreement, there’s a smaller chance for confusion or a misunderstanding among the parties involved.
A large loan that doesn’t have a written loan agreement could invite IRS scrutiny. It may even be considered a gift, and you as the donor would be subject to a gift tax for the amount given that’s above a certain threshold ($13,000 in 2009).
Create an arm’s length transaction
“Offer the same repayment terms to your borrower that a bank would offer, and charge market interest rates,” Davis says. This is especially true for substantial loans (more than $10,000).
To determine a fair interest rate, refer to the current Applicable Federal Rates (AFR) that are released by the IRS. You can find them by asking your tax attorney or by visiting IRS.gov.
Be open to accepting payment in installments, Stallings says. That way, you don’t set yourself up for frustration if the borrower isn’t able pay back everything at once.
Once the terms of the loan have been met, create a release that offers proof for all parties that the balance was paid.
Keep the relationship
“If the borrower is unable to pay you back, it can be extremely hurtful,” says Stallings. “In that situation, the best thing to do is be honest and express your disappointment.”
She suggests revisiting the original loan agreement and asking the borrower what