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Lending money to loved ones: a realist's guide

By Peter Andrew

For Money Blue Book

Published: Tuesday, March 18 2014 12:00 a.m. MDT

A couple of years ago, some friends of ours had a problem. I was happy to help them with a loan, in part because in my mind it was a gift.

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Editor's note: This article originally ran on Money Blue Book. It has been reprinted here with permission.

A couple of years ago, some friends of ours had a problem. The vehicle they relied on to earn a big chunk of their income had broken down in a terminal sort of way, and they didn't have quite enough savings for a replacement. So I called and offered to lend them the $1,000 or so they were short. The relief and happiness in their voices were easily worth a thousand bucks. I followed up with an email:

"Glad we could help out. Just two conditions over the loan.

"First, let's keep it among the four of us (the two of them and my partner and me); nobody else needs to know, though there's no problem if you've already told someone. And, second, we mustn't let it get in the way of our friendship. With luck, you'll be able to pay us back fairly easily, but we really don't care if it takes 10 years or longer. So don't ever avoid seeing us just because you're worried we'll be nagging you over it. We never will."

Make loan, think gift

In my head, the loan was a gift, though I couldn't tell them that because they never would have taken it. If I eventually got the money back, that would be a fine surprise, but it wasn't an expectation. Had it been so, and I'd later been disappointed, it would have cost me two friendships that were worth far more than a grand. Shakespeare made a sound point in "Hamlet" when he wrote, "Neither a borrower, nor a lender be; For loan oft loses both itself and friend."

It's true. If you borrow money and can't pay it back, you avoid the friends or relations who lent it to you. You never call, you duck into a store if you see them in the street, and you abandon your half-full cart and flee Target if you spot them in the next aisle. You don't want to speak to them because you feel guilty and are terrified of the direction the conversation might take. Meanwhile, resentment builds up in the lender over the loss of both the money and the relationship.

When it must be a loan

Coincidentally, my friends needed money during possibly the only brief time in my life when I could afford to give away $1,000 without it hurting too much. Normally, I'm way too broke even to consider such a gesture. So usually, I'd not have offered, although, if a friend or relation were desperate enough, I guess I'd consider making a real, repayable loan.

But that's when things get dangerous. In 2012, academic psychologists George Loewenstein and Linda Dezsö published a study, "Lenders' blind trust and borrowers' blind spots," which identified gaping chasms between how lenders and borrowers perceive loans. Borrowers tend to develop mental blind spots that make them overestimate the payments they've already made, while underestimating the resentment lenders feel about delinquencies.

One way of potentially reducing the risk of misunderstandings, at least for significant amounts, is to make the arrangement formal by drawing up a loan agreement. There are various ways to do this, with, of course, options available online.

Rocketlawyer.com, for example, has a loan agreement template that allows you, free of charge, to create an agreement in accordance with your state's laws. It has an easy-to-use wizard (I just tried it) that allows customization and prompts you to include items you may not automatically think of, such as late-payment fees and a penalty rate that kicks in if the principal isn't paid down by the final due date. It even offers amortization tables and a provision that allows you to sell the loan to a third party. I'm no lawyer and I can't speak for the legal efficacy of these agreements, but they look good!

Use your head as well as your heart

Sometimes, it makes perfect sense for individuals to lend to each other within a family or circle of friends. The borrower can pay less interest than he would for a bank, credit card, auto, home or home equity loan, while the lender can earn a higher yield than she'd receive from even the best savings accounts. But that only works if the borrower makes payments.

You know your kids, siblings, cousins and friends well. You know which are naturally brilliant money managers — and which are lovable deadbeats. You need to use that knowledge to make hardheaded lending decisions. Otherwise, the loan may turn into a gift, whether you want it to or not. It's that or you stand to ruin your relationship with someone who's very important to you. As Benjamin Franklin once observed, "Creditors have better memories than debtors."

Peter Andrew has over 25 years of experience writing about marketing, advertising and management. He regularly covers consumer credit card topics for Fox Business, TheStreet and MSN Money.

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