Lending Money to Family and Friends: Two Factors to Consider

We are frequently asked financial questions that really don’t have an entirely financial answer. A recent question went something like this: “Evor, I have a friend who needs help qualifying for a mortgage loan. I would like to cosign on the loan to make sure she gets it. She’s financially solvent, and there’s an almost nonexistent risk that she would ever default on the loan. What do you think?”

Clearly, this question has two aspects: a personal/emotional aspect and a financial/risk aspect.

How might you have answered that question? Your answer may tell you a bit about yourself and your relationships with your friends and family, as well as your appetite for taking on financial risk. As comprehensive financial advisors, we almost always consider both aspects.

I’ll start with the cold financial aspect:

  1. If the friend was not able to qualify for the loan on her own, then how do you justify the opinion that “she is solvent”? Solvency comes in many forms. The most commonly overlooked aspect of solvency involves the perspective of time. We frequently speak with people who have $1 million in the bank and who have horrible spending habits. They are bankrupt (insolvent)—it’s just a matter of timing. The $1 million has already been irrevocably earmarked for emotional overspending. It’s a simple, human behavioral fact borne out by huge volumes of research on the power of habit: We commonly let ourselves be fooled by not seeing money in the appropriate framework of time—time tends to fool us into thinking that things will be OK or better in the future.
  2. Are you willing to risk your credit score (and livelihood) for your friend or family member? I’ll give a worst-case scenario (not uncommon) to illustrate this point: Let’s say you agree to cosign on the loan. Your friend ends up defaulting on the loan (also not uncommon), and your credit score is dragged into the gutter. Then you have a business or job opportunity that requires a good credit score. Now you’re faced with the reality of your decision to cosign. The job opportunity is given to another candidate; or if your business really needed that line of credit, you can’t get one or the interest rate is exorbitantly high. There are real-life and severe impacts.
  3. Is your friend willing to sell the house if they are headed for a likely default? We would advise our client in this case to implement the legal ability to force a sale of the property or asset should your friend default on a loan. In reality, if your friend cannot pay, you will have to until the asset is sold in order to preserve your credit. You will need to set up and maintain a joint emergency fund just in case your friend cannot make payments. This is an important, yet highly uncommon, action taken when entering these types of deals. The emergency fund should be funded and maintained by your friend but kept in a jointly held account to which you both have access and viewable rights. This way, you have a buffer between your friend’s financial behavior and your personal financial health.

Now let’s look at the personal aspects:

  1. To be responsible for yourself and your financial well-being, you would definitely want to look into your friend’s finances. This includes reviewing spending habits, bank and credit card statements, present or future employment prospects, and earning capability. Typically, this type of review would be seen by friends as a cringe-worthy intrusion. If your friend can’t qualify for a loan, they’re probably not going to want to answer questions about bad financial decisions. Consider how willing your friend is to “lose face” in order to get the deal done.
  2. Are you willing to lose your friendship to help out? I can’t guarantee what would happen if your friend defaults or doesn’t pay you back, but I can say that most of the time the friendship would end … and badly … and possibly in court.

How do you say no to a good friend who asks for financial help? You could say, “Look, friend, I know you’re in need of financial help, but my friendship with you is far more important than letting money get in the way of that. As a parent/spouse/individual, I simply can’t take on the financial risk that you’re asking me to do.” Or, “I promise to help you in whatever way I can, but I have always had a strict personal rule when it comes to friendships and family—that is, I never, ever let money get in between our relationship.”

Sometimes I tell my more sensitive clients to blame the decision on their financial advisor. I’m happy to take the heat and be the bad guy in the situation!

A last alternative is to “lend” an amount of money to your friend or family member that you are willing to forever let go and truly, honestly, never expect to see again. In addition, you must not allow this amount to get in the way of the personal relationship. In other words, you can say, “It’s a loan,” but in reality, you know it’s a gift.

Not all friends and family are the same, but it is common to have these types of loans or financial support go un-repaid and end badly for both parties. Just be careful, and know that friendship and money don’t always mix.