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.”
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?
“A bank would not lend you money without looking at the three Cs—character, cash, collateral. If I am lending you $10,000 and you’ve invested $50,000, at least I know you have skin in the game, but if I’m funding the entire operation, that’s wrong,” he says.
“It pays to sit down and reflect on the conversation, rather than having a knee jerk reaction and saying sure here is the money because I feel guilty or there is no way in hell I’m going to lend it to you.”
Outside of that, Bryck says, as a family member, it is important to lend only what you absolutely can afford to lose. If someone is borrowing money for a business, there is risk involved.
“Entrepreneur means one willing to accept risk. If you are lending to an entrepreneur, you are an entrepreneur,” he says.
Online Lending Solutions
Bryck recommends using an intermediary like Virgin Money USA. It's documents formalize loans between people who know each other; users can create and customize them outline, says Sarah Deklin, Virgin Money USA Chief Marketing Officer.
“It is certainly not a bad thing to lend money to family and friends, and can be extremely productive for both parties,” she says, “but what is important is that you talk ahead of time to make sure that everyone is clear on what the expectations are around the terms and the timing and schedule of repayment.”
Parents frequently use this service to lend money to children for college or to buy homes, and friends and colleagues, lend to each other to start or fund businesses. There are requirements on the state level about what consititutes an acceptable interest rate.
On the low end, you need to charge a minimum interest rate or the lender could be subject to a gift tax, and on the high end, you need to charge interest rates under a certain threshold which varies by state, otherwise it could be deemed usury.
“Typically, at the end of the day, what happens is the borrower is getting a lower interest rate than they would get from a traditional lender, and the lender is earning a higher interest rate than they would on a typical fixed investment.”
Fuscaldo could have used Virgin Money US, legalzoom.comor nolo.com to customize or download a promissory note or other legal documents.
Bryck shared that, on a personal note, twice he lent a few thousand dollars to friends, and both times, he wasn’t paid back in what was “loosely defined as a reasonable period of time.”
So, what he wound up doing in each case was going to his friends and basically writing off the loan, saying that their friendship was more important than the money.
The unexpected outcome? Each time, Bryck wound up getting paid back. Once, because his friend felt so shamed by the conversation that he returned the money, and the second because the next day, ironically, his friend won money and gave it to him.
At this point, may be Fuscaldo's best and only hope of getting repaid.