What You Need to Know Before Lending Money to a Family Member

By | July 27, 2011

To some people, family and money are like oil and water – they just don’t mix. And yet oddly there’s no good way to separate family from money. We send our kids to school, buy each other Christmas gifts, feed each other, and ultimately share our lives and finances with each other.

That is the kind of reasoning many people employ when they think about loaning money to another member of their family: they want to share their blessings and help someone they love who’s in dire need of the money. But is this what every family loan looks like, or are there more nefarious situations that might require a bit of legal advice?

Naturally, we wouldn’t have an article to write if no one ever had problems loaning money. So let’s take a closer look at the potential problems loans can cause even when it happens in the family.

A Great Rule of Thumb

Writing for Money Magazine, Walter Updegrave presented this rule of thumb for loaning family members money: only make the loan if you can afford to lose the money. Like gambling, it’s a great way to ensure that the money you put out there doesn’t end up ruining you. And when the money you loan to a family member is not money you need, then it will cause much less stress if they cannot pay it back.

Extending the logic behind this rule of thumb, it’s a good idea to assume, when making a loan that your family member is not going to pay back the loan. It might sound like a cynical stance to hold, but it’s definitely a healthy one for your bottom line.

The key here is to avoid rationalizing how much money you really have to spend: “but my family member is in real trouble, and I have the money…shouldn’t I help out?”

But if you take the “skeptical” approach and assume that your family member will lose all of the money, then you’ll know whether or not you really can afford to lose it.

After all, a family member in need of money has demonstrated that they’re poor at money management. Loaning them more money won’t magically solve their problems in the way they might be intimating that it would. In fact, you may be doing them a favor by withholding your funds; they’re the ones who have to stand on their own two feet after all.

The Power of Contracts

Now that we’ve gotten past a great rule of thumb for dealing with family loans, it’s time to lay another solid brick in our foundation: understanding contracts. Don’t ever make a loan where you don’t have a contract explicitly stating what’s happening and how the loan will be paid off. Some people will claim you can rely on verbal agreements, but when you have something written and signed, it’s more ironclad.

Signing a detailed loan agreement should not be considered voluntary; it should be considered mandatory. Let’s say your family member was insulted by the idea of a contract and didn’t want to sign. What does that tell you about their confidence that they’ll be able to pay you back? It probably reveals what was going to happen all along: they were going to take the money and come up with excuses as to why they wouldn’t be able to pay you back.

When you have a written agreement along with the loan, then you’re able to establish the loan’s validity in a court of law. This will give you enormous power, but that doesn’t always mean you should wield it. Money is a difficult issue that can tear families apart – you want the contract to guarantee you have a power you’ll hopefully never have to use. It’s like learning self-defense in the hope you never have to use your skills.

Consider this not only a rule of thumb, but a mandatory rule in your household: money only gets lent if a detailed loan agreement is signed. If your family member doesn’t feel like you trust them, that’s their problem and not yours. If they really need the money and are grateful to have it, they’ll be happy to sign your agreement and will promise they live up to every detail.

Dealing with Family Issues

A loan between family members gone wrong can cause a great deal of strife amongst family, but that’s no reason not to help out someone in need. In some cases, not granting the loan can cause strife just as much as granting a loan. It puts you in a tough spot, to be sure, but remember: you’re not the reason for these problems. You’re the one with the money; don’t feel like you have to do anything with it you don’t want to.

It’s generally good to avoid combining family and money whenever possible. Sure, share your resources; host each other, share the cabin on the lake, buy each other dinner. But when it comes to more serious financial matters, you should be prepared for more serious problems and act accordingly. This doesn’t place a limit on your ability to help out family members in need. It just requires that you examine the loan with a discerning eye and know how to protect yourself in case the loan goes bad.

Unless you’ve started acting like a loan shark, you generally won’t be to blame for any family strife that’s caused as a result of ill feelings over money. So keep the attitude that you love your family and that you’re willing to help whenever you actually can without putting your own family at risk.  Be sure that everything gets written, despite the trust family members often have. If you cover all of your bases, you’ll find that you’re far more likely to make a successful loan.

It’s also important to read the borrower. You’ll likely know them well. Are they passionate about paying you back or do they expect the loan like it’s a welfare check? Are they happy to sign a contract or do they make you feel guilty about it? Trust your instincts, get it in writing, protect yourself, and you’ll be fine.

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