4 rules for those who lend money

Lending money always involves risks, whether it’s for personal or professional reasons. But lending to family or friends adds a layer of complexity. You could lose your money and strain an important relationship in the worst-case scenario. So before we consider that request for money, let’s first explore how to lend money legally.

This article mainly focuses on personal loans, which often get overlooked in terms of legality and agreements. Here are four essential rules to ensure both your financial security and legal compliance.

Rule 1: assess the borrower’s financial stability

Before extending a loan, make sure that the borrower understands that the money is not a gift. This clarity is vital not only for getting your money back but also for maintaining a healthy relationship with the borrower.

With that clear, to gauge someone’s financial stability, you can ask to review their financial statements. You can also opt for a more formal approach by asking them to provide a Personal Financial Statement, which outlines their assets and liabilities:

• Assets: cash, bank and brokerage accounts, savings, and investments
• Liabilities: credit card debt, car loans, mortgages, and unpaid taxes

By subtracting the total liabilities from their assets, you’ll get an insight into their net worth. You’ll need this information to decide whether lending to them aligns with your financial interests.

But if something comes off as a red flag, you can call it off. You must prioritize yourself and protect your interests. Set a clear limit on the amount you’re comfortable with lending, and if your limit doesn’t work for them, they can explore alternative lending sources like another person or a bank.

Rule 2: create a legal and transparent agreement

When you’re lending money, having a written loan agreement or promissory note is your best course of action. 

Some people might lend money based on trust alone without documenting the terms. However, this may lead to complications if the borrower doesn’t fulfill their part of the deal. On top of that, if there’s a disagreement about what was agreed upon verbally, there’s no written record to refer to.

By creating a loan agreement and maintaining a paper trail, you protect your legal rights. A formal agreement:

• Clearly states the borrower’s commitment to repay the loan;
• Deters the borrower from making claims that contradict the agreement’s terms;
• Outlines a repayment plan, specifying when it commences;
• Prevents misunderstandings or disputes.

You may have specific repayment preferences when lending money. Whether you prefer a single lump-sum payment on a designated date or smaller monthly installments over a set period, have all of that in writing.

How to make a loan agreement

Here are the fundamental terms to include:

1. Principal amount — Clearly state the amount borrowed.
2. Interest rate (if applicable) — If you’ve agreed upon an interest rate, specify it in the agreement. Not all loans between friends or family involve interest, but if they do, the rate should be documented.
3. Repayment terms — Outline how the borrower will repay the loan.
4. Contingency plans for non-payment — Address the actions to be taken if the borrower cannot meet the agreed-upon repayment terms. It may include:
   • Adding additional costs to the loan
   • Modifying the loan terms
   • Taking possession of collateral (if applicable)
   • Pursuing legal action as a last resort

Speaking of collateral, it’s something valuable the borrower offers to protect your money. For example, they might use their car as collateral. 

If they don’t have something of enough value, you can ask for something important to them. This gives them a reason to stick to the terms. It may sound harsh, but communicate that it’s not something you want — it’s solely for security.

Rule 3: document all transactions

Once the lender and borrower agree on terms, both sign the agreement in the presence of independent witnesses. Each party should keep a signed copy of the agreement for reference. This step establishes a clear record of documents.

The next key step is transferring the money to the borrower in a manner that leaves no room for disputes. The recommended methods are direct bank transfers or issuing a cheque. These generate indisputable proof of the transaction and assure both parties that the funds have changed hands as planned.

After the money has been transferred, the agreement becomes effective, and even then, diligent record-keeping stays paramount. As a lender, you’re interested in maintaining detailed records of the initial transfer and tracking all repayments. It’ll also be helpful to document any communications related to the loan, like screenshots and emails.

Rule 4: maintain follow-up and communication

Financial ups and downs are a part of life, and when they involve close relationships, they can become particularly uncomfortable. If loan agreements are overlooked or broken, it will most likely strain bonds formed over many years or even decades. To prevent such rifts, keep communication lines open with the borrower, particularly when things start to get murky. This is your best tool and defense against potential animosity.

For borrowers, it’s good practice to provide periodic updates on their financial status, whether monthly, quarterly, or annually. This keeps you, the lender, informed about your business’s performance and any potential repayment challenges. It also allows for discussions about alternative relief options.

Lastly, no matter how unlikely, both parties should anticipate potential trouble spots and decide on how to address them proactively. You want to prevent heated arguments over debt and preserve valuable relationships. It may not be ideal, but the goal is to make it a positive experience for everyone involved, as agreed upon.

How to collect a debt if a borrower won’t pay

If a borrower refuses to repay, you can either send a demand letter or file in small claims court. 

A demand letter is a written request sent to the borrower for the obvious reason — asking for payment or action to resolve the issue without going to court. It should state the purpose, request payment by a specific date, and mention potential legal action. You can deliver it in person, through a lawyer, a friend, or by registered mail.

If the borrower doesn’t respond to the demand letter, consider filing a claim in small claims court. It’s a harsher way to resolve minor disputes than simply asking, but sometimes, it needs to be done. Legal representation may not be practical because of the high fees compared to the amounts involved in small claims cases.

Bear in mind that the limits for small claims courts vary depending on where you live.

Is lending money to friends and family a good idea?

It depends on your financial situation, relationships, and goals. Here are some key considerations:

• Can you comfortably lend this money without affecting your own financial stability?
• If other lenders have said no, does the risk seem worth it? 
• Would you be willing to take the legal route in case of non-payment?
• Are you willing to forgive the debt if it means preserving your relationship?

If you answered yes, lending might be a feasible option. If giving away this money would hurt your finances and your relationship badly, it’s a good reason to say no.

When it comes to loans and finances, it’s important to make a clear distinction: trading should never involve money borrowed from friends or family. Binomo strongly promotes responsible money management and advises against trading with borrowed funds. 

Sources:

Loans: your essential guide to lending money, LawDepot

Family loans: how to borrow from and lend to family, NerdWallet