If you’ve helped out a loved one when they’ve been short on cash, you’re in the majority. A LendingTree survey found that 51% of respondents had loaned money to a friend or family member in the previous five years, and 27% of the time it was to a sibling (1).
Now, imagine you’re 36-year-old Mia: Her sister, 30-year-old Olivia, works freelance and in between gigs, she’s often short on rent. Mia has helped her out multiple times and fears that it’s becoming a crutch. She’s frustrated by the situation, and worries Olivia won’t learn to stand on her own two feet if she keeps bailing her out.
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Helping out family or a friend when they’re in a financial bind may seem like a no-brainer, but you need to consider all the risks that go along with it — including possible strain on your relationship.
Consequences reported by lenders and borrowers in the survey included hurt feelings (14%), resentment (10%), arguments (6%) and uncomfortable family gatherings (4%).
Let’s take a closer look at the risks and if you decide to still lend the money, how to do so responsibly.
Financial and emotional risks of lending money
Even if you have enough room in the budget to pay for your own expenses and lend extra money to family or friends, you still want to be careful. Think about where you’ll pull the money from: Will you dip into your emergency fund or into funds you set aside for taxes?
Lending money that you need yourself means potentially putting yourself in a precarious financial position.
More than 1 in 5 borrowers in the LendingTree survey reported not having fully paid back a loan. If you were the lender, you’d now need to figure out how you were going to meet your own financial obligations. It could mean taking out a loan yourself (and paying interest) to make up for the shortfall.
Even if you can afford to lend money, you also risk your relationship suffering if the borrower doesn’t make payments as promised — or is unable to pay the loan back at all. Other consequences reported by LendingTree include decreased contact between the lender and lendee 10% of the time, and even irreparable harm to the relationship another 4% of the time.
You’ll want to carefully consider whether these risks are worth it, and put steps in place to mitigate them.
Read more: I’m almost 50 and have nothing saved for retirement — what now? Don’t panic. These 6 easy steps can help you turn things around
How you can lend money responsibly
If you do decide to lend money, be sure to check that you can afford to first. After that, setting clear expectations about the loans is key.
Create a loan agreement
Creating a written loan agreement can help prevent any issues or miscommunication when lending money. At the very least, the agreement should outline the amount you lent and the repayment terms.
Other details you may want to put into the loan agreement:
- Interest rate, if you decide or need (see below) to charge one.
- Repayment amount and cadence.
- When the loan needs to be repaid in full.
- What happens in the event the borrower can’t repay the loan.
Share this document with your family member or friend before lending the money. That way, they can decide whether to agree to the terms. Having open and honest communication from the very beginning ensures that everyone can address questions or concerns about the loan.
Though it may cost you some money, having this document notarized signifies that you take the loan seriously — and so should the borrower.
Understand any tax implications
You are required to charge interest if you lend a family member or friend more than $10,000 (2), according to the IRS. The amount should be equivalent to the AFR, or the applicable federal rate (3).
Interest you collect counts as taxable income. It is up to you to determine how much interest you want to charge. However, if you charge a rate lower than the AFR, the IRS may still charge you taxes based on the interest you should have earned.
Be OK with saying ‘no’
Even though it’s an uncomfortable situation, you need to be prepared to say ‘no’ to requests to lend money to family and friends.
At the end of the day, you need to look out for your best interests. It may not be worth risking your financial security to help someone else, especially if it means you could be left in dire straits. Not lending to friends or family because you don’t want to risk ruining the relationship is also a perfectly valid choice.
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This article originally appeared on Moneywise.com under the title: My sister freelances and often comes to me to borrow cash for rent when she’s between jobs. Is it time to cut her off?
This article provides information only and should not be construed as advice. It is provided without warranty of any kind.