It's harder than ever for young adults to save and get ahead in our current economy. Modest incomes and college loans make it tough to assemble enough cash to purchase a car or make a down payment on a house. It doesn't help that credit standards have tightened, putting bank loans out of reach for those without a strong credit history.
It's no wonder people are looking to family members for some financial help, and while you may want to help, lending to a family member isn't always the best idea. Here are a few reasons why:
Tricky to negotiate
When family is involved, people tend to think with their hearts rather than their brains. Settling on terms that are agreeable to both people involved is easier said than done. One person may view the loan as more of a favor or obligation than a business transaction, setting the stage for misunderstanding. And when opinions differ about the size of a loan and the terms of repayment, it can be difficult to find common ground.
Lack of enforcement
A conventional loan has built-in rules that help keep borrowers on track. In contrast, there's often a nebulous framework surrounding a family loan. If there's no consequence for a late payment, there's little incentive to make payments on-time. As a result, a loan to a family member can stretch from months to years to decades, simply because it can.
Money has a way of driving a wedge between the best of relationships. A family loan changes the dynamics between even the most well-intentioned family members. A loan tips the balance of power, and one or both parties may find themselves feeling resentful once money has changed hands. Suddenly the lender has the upper hand, and the borrower may feel angry at the lender's scrutiny of spending habits. Similarly, the lender may feel entitled to be more involved in the borrower's personal life, creating unpleasant friction.
A loan within the family can cause problems beyond the borrower and lender. Other family members may frown on the loan. Siblings or cousins may be jealous. Grandparents may feel protective; parents may want to intervene. Aunts and uncles may take sides. As more people and emotions are dragged into the fray, the stickier it can be.
High potential for default
Individuals who borrow money from family members often do so because their credit is shaky, which likely means the risk of default under these circumstances will be higher than average. The takeaway? Make sure you can live without the money before you part with it.
Poor rate of return
Lending money to a family member is rarely a good investment if you're weighing your return in hard dollars. You may never see a dime of principal, let alone interest. If you're satisfied knowing your money helped someone you care about, then you may be okay with a low rate of return.
No going back
Once you've extended a family loan, it's hard to undo. The money is out there, with uncertain promise of return. Feelings can be easily hurt and difficult to repair. If you can't afford the risks that come with loaning money to a family member, you're well within your rights to say no. But if you do decide to provide a financial loan to a family member, do yourself a favor and consult an expert. Meet with your financial advisor to determine how a loan will impact your overall net worth and what steps you can take to make up the deficit. It's also a good idea to draw up an agreement with terms of the loan, including clear expectations for repayment.