How And When To Lend Money to Family And Friends

Five years ago, Dorothy Fuscaldo, a personal trainer in Westchester County, N.Y., lent $5,000 to a close friend, someone she considers a sister.

“She was having problems at home, with her family, and she wanted to be out on her own,” Fuscaldo says. So, Fuscaldo agreed to lend her money toward a down payment for an apartment. A few months later, her friend decided not to buy her own place. Instead, she got into a relationship and moved in with the person. Fuscaldo, on the other hand, never got her money back.

Though the loan has come up in conversations over the years and they remain close, Fuscaldo has never asked her point blank for the money.

“'I know I still owe you the money, but right now I got this, that and the other thing,”  she recalls her friend saying, “Now what do you do.”

"What pissed me off,” Fuscaldo says, “is that she bought a motorcycle about two years ago. It was not a necessary item, medical bills I would understand. That could have been my three thousand dollars.”

Current DateTime: 10:49:13 09 Feb 2012
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Even though it doesn’t look likely, Fuscaldo still feels somehow, she will get the money back.

What can we learn from her?

Rules of the Road

If Fuscaldo had spoken to Dennis Stearns, President of Stearns Financial Services Group in Greensboro, N.C., she might have done things a bit differently.

Though Stearns does not believe like some that it is never a good idea to lend money to family or loved ones, he says, “we try to determine what type of situation it is and that a lot of times determines whether you should do it or not.”

It also establishes how much structure and interest to charge. Though his philosophy is based on parents lending money to their children, he says it can also apply to other close relationships with some caveats.

Stearns’ schema for identifying good and bad borrowers includes three primary types.

The first category Stearns describes as “Grounded.” These children have run into temporary problems and may need a onetime fix. They tend to pay parents back and it tends to be a very positive thing that they are helped out, so there is no real harm done to the relationship.

“We’ve done two of those loans just this week and we encourage them all the time,” says Stearns.

He calls the second type “Accident Prone.” This child gets into trouble occasionally, and needs more structure in the loan in the form of written documents and also more coaching. They frequently need to have a family member or a financial advisor talk to them through the situation and how to avoid letting it happen again.

The key is to make sure they don't drift towards becoming type three, what Stearns calls “Maladjusted.” This type always seems to need more money, and the money perpetuates further poor decisions or bad behavior.

“These loans need lots of structure and sometimes tough love, or not bailing them out, is the right answer,” he says. Type three people almost always require counseling by a financial planner, accountant or family lawyer.

How much interest should you charge in each case?

Stearns recommends using the short-, mid-, and long-term rates that the IRS mandates under the Applicable Federal Rate. The short-term rate of 0.57 percent is great for type one and some type twos. The mid-term rate of 2.45 percent represents most loans to type twos and threes, but in some cases the long-term rate of 4.11 percent is necessary.

Business Before Friendship

Though some of the same thinking applies, there is a bit of a difference when the loan is funding a business venture, says Ira Bryck, Director of the University of Massachusetts- Amherst Family Business Center.

These days, with the lack of access to capital, he says he sees a lot of small- and medium- sized companies that need money, and they are going to friends and family to borrow, “even though it is really hard for friends and family to act professionally or to say it’s just business.”

If asked for a loan, Bryck recommends sitting the person down and giving them a five-minute speech something on the order of: If you are going to use me as your bank, than I am going to act like a bank and I am going to ask what is your business plan, what is your return on investment, what sort of risk am I taking?