Today’s post is about lending money to friends and family, which I suspect is quite a contentious issue for most people, not just our little FI/RE blogging community. I’m not sure if this post will be just as contentious but we’ll soon see…
I recently read about our next life‘s plans to make a loan to a family member and it immediately rang alarm bells for me. I have had a fair bit of exposure to this concept, both within my broader family and also for clients at work, and it really does seem fraught with danger. I actually wrote this post before Our Next Life published their detailed post on this idea, and while their post explains their rationale for making a loan to someone close to them, I thought there would be value in putting a bit more detail out there of my experience with this issue.
As many aspiring early retirees will accumulate significant wealth, it’s quite likely that their friends and family will hit them up for a loan, and I think it’s therefore important that people are aware of the risks before getting in too deep in this area.
In my opinion, some of the risks or issues with lending money to friends and family include:
1. Contrary to popular belief, responsible banks don’t lend money to people if they don’t believe that they can realistically pay it back.
I’m often amazed when people (mainly clients) complain that their bank wouldn’t loan them any money, especially when they say it like the banks are doing it just to be pricks. What people don’t understand is that banks need to have a chance of actually getting their money back, and if they won’t give you the money then either you don’t have a chance of paying it back, or you weren’t smart enough to actually put forward a compelling proposal. If either of these things are true, then I’d say that there’s a very good chance that you don’t actually deserve to be lent the money.
As soon as someone blames a bank for not lending them money I immediately reassess their financial intelligence (and their credit worthiness), and someone that scores poorly in these areas isn’t exactly an ideal candidate for a loan in my opinion.
2. If they can’t get a loan from a bank, what makes you think that they can afford to pay you back?
Now it’s not uncommon for people to not be able to get a loan from a bank, but this should be a sign to them that what they are seeking to do probably isn’t a good idea. Admittedly, people may not always know what banks will do to assess loans, with most reputable financial institutions having significantly tightened their lending criteria from quite frankly ridiculously loose parameters that they used prior to the global financial crisis, but after a knockback from a bank they really do need to reconsider whether their plan is viable.
Unfortunately some people don’t think about it this way, sticking to their grand plan and thinking that all they need is someone that can see their vision. And of course, that’s where they turn to their family and friends.
For me, if I ever hear this (and I’ve heard it from clients, and from family and friends that have been approached for loans) alarm bells start ringing in my head. If you hear even some of the most basic details of their situation (e.g. “We under-estimated how much money we’d need to settle on our house purchase and we’d like to borrow $25k from you, we’ll pay it back really quick, honestly”) you should be very worried about whether you will ever be able to pay you back at all.
3. They may be seeking a loan from you thinking that they won’t have to pay you back if they run into trouble.
Just about every family has an example of a loan within the family, and a large proportion of those loans don’t actually get paid back. At least that’s what I have seen with clients at work (and for some big sums as well), and hear about anecdotally among friends.
Given that this is what so often happens, perhaps people could be forgiven for assuming that they won’t have to pay a loan back to a family member if they run into trouble, or that they can easily string it out for longer (i.e. increase the loan term) or have a good chance of any agreed interest being wiped out (i.e. that the interest rate will be dropped to nil).
4. If they don’t pay the loan back on schedule then you may not be prepared for the relationship fallout.
I’ve seen plenty of loans not paid back on time, and the lender usually doesn’t have a leg to stand on in these circumstances. They can’t garnishee the borrower’s wages, they’re not going to put a black mark on the borrower’s credit rating, and it’s extremely unlikely that they’re going to send out a payment demand notice.
If the lender takes any action to get the money back if the person slips behind then there will almost always be a fairly serious relationship fallout, and I’m rarely convinced that people have given this enough consideration. Pretty soon the relationship goes from one of equals, with love, care, friendship and all of those other nice things, to one where the lender has something over the borrower. If the borrower is behind on their payments, then the lender could be forgiven for being pissed if they see the borrower down at the pub spending their cash that could have been used to make a payment on their loan. And while I haven’t actually seen it yet, I doubt it would be pretty to see someone hit up for a loan payment when they’ve downed half a dozen pints of their favourite brew down at the local!
5. The large majority of loans to family and friends have a negative effect on the relationship, even if they’re paid back on schedule (which they usually aren’t).
As I touched on above, a loan between family and friends often changes the relationship from one of equals to one more like servant and master. Even in the best of circumstances, this just has a negative effect on the relationship, with the borrower always looking over their shoulder to make sure that their lender is happy (or isn’t unhappy).
And if someone is your best friend who would never rip you off then you really need to ask yourself whether you are prepared to sacrifice such a great friendship for the sake of a loan.
6. You will be making these loans using funds that may possibly form a significant part of your net worth, and putting these funds at risk could have a huge effect on your early retirement goal.
Everyone in our online FI/RE community is looking to build their nest eggs, and every little bit counts. While it might be fine to lend a couple of grand to a friend as it won’t make a huge difference to your $500k stash, lending your friend $50k so that they can buy a house is an entirely different matter.
Depending on where you are up to on the path to retirement, losing something like $50k, $20k or even $10k could have a huge effect on your retirement planning, potentially adding years onto your working life. You really need to ask yourself whether you are prepared to work a number of years more if the loan goes bad.
7. As you become wealthier, and people become aware of it, they feel less guilt or concern about things that affect you financially (like financial loss).
I see this with wealthy clients who lend money to their kids, and I even see it in simple ways like the attitude of some people that know me towards my own situation. They say things like “Oh well, you make much more than I do, so you can earn that money back in no time, but for me that’s a really big deal”, and while they are right in theory, they actually care a lot less about any potential financial loss that you may incur. Now of course that’s something that you can understand if not condone, people that have that sort of attitude are exactly the wrong type of people to lend money to. If someone doesn’t feel any guilt about not paying you back, what sort of chances do you think you’ll have of getting your cash without knee-capping them?
Now before anyone says it, let me make two important points/disclaimers:
- I know that some of this stuff is a bit harsh and impersonal, but if we’re serious about achieving financial independence we need to look at better solutions for people that are chasing a loan. With everything we know and learn from our FI/RE community, we could offer far better value by guiding and mentoring family and friends into a more financially responsible way of life. That’s something that costs us nothing (in dollar terms), but could cost quite a bit of time if we are committed to helping them to improve their financial wellbeing. Unfortunately many of them may not see it this way, with a “why can’t you just give me the money?” being the attitude that prevails in their minds, in which case they will just move on to the next sucker who can lend them cash. If that’s the case, then you were probably best not to lend them money anyway!
- If your beloved family member or best friend has contracted an extremely rare form of life-threatening UFO-inflicted herpes for which they don’t have insurance and need $10k to pay the aliens for a cure, then of course that’s something that you should lend them money for. We do love our family and friends after all, and I’m not a heartless bastard.
I hope that this provides food for thought on the matter of loans to family and friends, and would love to hear examples (good and bad) of when you or someone you know has made such a loan.