Lending Money to Friends Is Never Easy

If you are considering lending money to friends, think about the financial and legal repercussions of your action prior to taking the next step. Family or friend loans start off innocently. They are easier to secure and cheaper to pay than loans from a financial institution. However, if there is a change in the relationship between two parties or a change in the borrower's ability to pay, the lender can be left without options. Instead of blindly extending a loan to a friend, go through the process legally to assure you can protect your relationship and your finances.

Loaning Too Much

The most common problem that occurs when two parties extend a personal loan without consulting a financial adviser is simple: too much money is exchanged. This can cause a problem for the lender who may need the money in the future, but it can also cause a problem for the borrower if the money cannot be repaid. Neither side stands to gain from a loan that is simply too large. Address this issue by determining what a bank or lender would be willing to give the borrower. Start with this figure as your jumping-off point, and do not go too much higher. If the sum is more than you can afford to lend, do not extend the cash.

Failing to Charge Interest

Legally, you may be required to charge interest on a loan higher than $10,000. This helps the IRS keep track of the movement of the money. Further, if you do not charge interest on a large loan, you will lose money even if the loan is repaid. This occurs because inflation reduces the value of the money you eventually earn back when the loan is repaid. Ensure you are always charging interest equal to at least the value of inflation to protect yourself financially and legally.

Failing to Report Income

If you do charge interest, you have to report the income to the IRS. Failing to do so is a form of tax evasion. You may innocently believe that charging your son or daughter interest on a loan you provided in order to send him or her to school is your own prerogative. To the IRS, though, you are extending a loan, turning a profit and pocketing 100 percent of the cash. You must report and pay taxes on interest on any debt, and you should be particularly careful regarding debts over $10,000. 

Not Protecting Your Interests

Once you know how much you can lend and what you will charge, you should get the agreement in writing. You do not have to have a formal, legal contract in order to protect yourself. Instead, simply cover your bases. Record how much was loaned, the terms of repayment and a method for dealing with disputes or refinancing in the future. For example, if your friend cannot repay the debt on time but can promise to repay the debt on an adjusted schedule, you will need a process in place for making the adjustment. If your friend cannot repay the debt at all, you will need a process in place to handle the default.  

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