The Gift of a Loan

Questions to ask while lending to friends and family, and what it means for your relationship with them.

The Gift of a Loan
Some examples of consequences — positive and negative scenarios — that might occur when you say yes or no when a friend/family member asks you for a loan.

Imagine that someone in your friend circle or your family just asked you for money and you are not sure how to respond. Your hesitation doesn’t make you a bad person; you don’t have to feel guilty about having doubts about their ability to pay you back. This post will help you consider all possible scenarios, both good and bad, that might arise as a consequence of you saying yes or no. They key point is that negative scenarios can occur regardless of whether you say yes or no.

Commercial lenders often face the problem of information asymmetry. This just means that the borrowers know more than lenders do about their ability to make payments on time, and this imbalance in what each party knows can create problems. While commercial lenders have tools to offset the risk of information asymmetries such as using collateral, legal structures, pooling individual borrowers into portfolios, etc., you cannot use these tools. But information is still critical. You can ask questions. This post will give you examples of questions you can ask. So, you can understand what scenarios are plausible and make an informed decision.

Our goal is to minimise the likelihood of negative scenarios and maximise the likelihood of positive scenarios. Hypothetical scenarios can help you create a list of questions you can ask your friend or family member. Considering them can reduce the likelihood of unwanted unintended consequences. Please note that some of the questions below assume that you will negotiate and write a contract before loaning the money.

  1. Why should you write a contract? Lending to a friend or family member might end up “spoiling” the individual. You might unintentionally treat them like a child who is used to getting rewards instead of punishment for wrong behaviour. So being strict with money can help them in the long-term, even if they can’t see that in the immediate future. It’s a way of helping them take a step towards financial independence (reduced anxiety about mounting debt, healthy financial profile, etc.). The contract formalises the lending process and reduces uncertainties that might otherwise give rise to resentment in your relationship.
  2. Are you lending money for something that they want rather than need? Are you lending money when they clearly do not have the ability to repay? If you answer yes to both of these questions, then they might end up in more debt because of you. Consider gifting the money in such situations rather than loaning it. It’s usually a good practice to loan money only when you can afford to lose it. Being in debt is stressful and can make your friend or family member feel worthless.
  3. If you say yes to your friend or family for the loan, and if they ask you for money again after a certain period of time (for example, a month later), how would you respond? Assume they haven’t paid the money you gave them last time back yet. What would you say when they try to suggest that the money you give them this time will help them make both payments? If you want to avoid such a scenario, you will need to mention this in terms and conditions of your contract and prepare for it if it occurs in future.
  4. What happens when they can’t pay you back? When do you decide that they can’t pay you back? Set a timeline for payments. Commercial lenders have a threshold like 3 months, and if a borrower surpasses this threshold, the loan status is changed from active to default. As someone who is dealing with a loved one rather than a stranger, your friend or family member might be embarrassed to say that they don’t have the means to pay you back. As a result, they might keep postponing the payment indefinitely. Talking about money can make you both uncomfortable, so making roles and responsibilities clear in the contract before signing it will help both of you in the long run.
  5. Are you considering an interest-free loan or a loan with interest? If the latter is true, then how would you set the interest rate? If your friend or family member encounters problems in future, would you be willing to lower or remove the interest rate? How will you adapt the interest rate or regular payments to your changing circumstances and their changing circumstances?
  6. If you hadn’t given the money, how would you have used it? When you decide to lend money, you have to consider opportunity costs. For example, sometimes money can be diverted from needs and wants of your other family members or your needs and wants. Is this likely to give rise to feelings of resentment in the future? Even though this does not directly affect your relationship with your borrower friend or family member, your relationship will be indirectly affected because the tone and mood of your conversations with them will change. This is why having honest and open conversations with all stakeholders (spouse, borrower, other lenders who might be contributing, etc.) is crucial.
  7. Are you having these conversations in front of others who are not participating in the contract or who have no stake in it? This can be problematic. For example, when your borrower friend asks you for money in front of other friends, you might feel peer pressure or feel obligated to say yes. Thinking about these conversations beforehand and coming up with numerous ways you can respond can help you make more rational decisions. For example, you can request a one-on-one meeting.
  8. Does lending money make you feel like you’re in control of someone else’s life? Lending can create power imbalances or feelings of superiority and inferiority in a previously balanced relationship. You might unintentionally behave in ways that your friend or family member might find annoying. For example, do you find yourself telling them how to use their money? The money was yours and now it is theirs. Until they give it back to you, it’s theirs. But you can ask questions to understand how they will use your money before signing the contract. You can negotiate with them and come up with an agreement where they will give you regular updates about their financial situation. For example, ask for access to their bank statements. Defining and respecting each other’s boundaries is critical for ensuring that the informal loan contract does not damage your relationship.
  9. How will you fund this loan? Will the money come from your savings account or your salary? For example, if it comes from your salary, either your other monthly expenses will decrease, or your monthly savings will decrease. Have you considered all possible consequences of this decrease?
  10. Have you considered all possible options to minimise your risk? You can reduce your risk by sharing it with other family members or friends who may be willing to contribute to the pool of money for the borrowing friend or family member.

Regardless of whether you say yes or no, your relationship will change. For example, if they repay on time and you experience no major conflicts during the payment period, your relationship will get stronger. Giving them no answer often hurts more than saying no and explaining why you are saying no. Although your relationship will inevitably change, you can control which direction it changes in by preparing for all possible scenarios.

An AI tool — copyAI’s text generation tool that uses OpenAI’s GPT-3 model — was used to create raw material for this post. My job was to mould this raw material and edit rather than write from scratch. It didn’t take me very long to write my first paragraph because I didn’t have to deal with a blank page. I did end up re-writing and adding to the model-generated content, but the overall experience of writing was less exhausting.

Thanks to Kumar Tanmay.

This post was originally published on Medium by Drasti Shah.