When a friend or relative asks for a personal loan it can put the prospective lender in an uncomfortable position. Instead of rejecting the request out of hand or whipping out your wallet, take some time to ask yourself a couple of critical questions before you make a final decision:
1. Can you afford to lend the money?
There is no guarantee that your money will be repaid unless the loan is secured with adequate collateral. If you cannot afford to lend the money you should reconsider the loan or ask for greater security from the borrower.
2.Is this an emotional or business investment?
Decide whether you are going to make this loan based on an emotional connection to the borrower or treat the loan as a purely business transaction. If you are going to evaluate the loan on purely emotional terms, you may decide to provide the borrower a below market rate. If this loan is purely for business purposes, you may want to be more stringent on the interest rate and loan terms.
3. What is the opportunity cost of the loan?
Lending money to a friend or relative means that your money will not be invested in some other asset. Consider the trade off between the return you expect to receive and what you anticipate you would receive from some other investment like a CD or Money Market account.
4. How could this loan affect other friends or relatives?
In evaluating the loan request ask yourself how the loan might affect your relationship with other friends or relatives. If you lend money to your friend Bill to start his hot dog cart will you damage your relationship with your other friend Sam who has been asking for capital to start his tire shop?
5. Is the borrower serious about repaying this loan? Does the loan make sense?
When you review the loan proposal from the borrower, does it seem realistic? Does your past experience with the borrower give you confidence that they will take the repayment of the loan seriously? If the loan is for a small business does the business plan make sense? When evaluating the prospects and purpose of the loan, would it be a good investment if you didn't have a personal relationship with the borrower?
6. How will the loan impact your relationship with the borrower?
If the loan goes bad for some reason, can you deal with having a strained relationship or no relationship with the borrower? If not you might want to take your lumps immediately and say "No". You should ask yourself whether or not you can stay out of the borrower's business even if the loan is current. The obligations of the lender and borrower should be spelled out in the loan agreement. For example, if you lend your friend money to open a coffee shop, it doesn't give you the right to dictate what kind of coffee to sell and at what price.
7. How are we going to make this loan work?
Negotiating the terms of the loan and writing the check are easy compared to patiently tracking the performance of the loan over its life, especially with a loan term of two years or longer. After you have settled on your loan, it is critical that both parties settle on how they will track the loan using a service like LoanBack.