Securing Money from Friends and Family

Meet Susan, a young stationery shop owner who needs additional cash flow to grow her inventory as the wedding season approaches. She is enthusiastic about being in business for herself and becoming a successful retailer. On advice from a friend, she is encouraged to avoid commercial lending institutions and borrow money from someone she knows. Her brother-in-law is a likely source for $6000.

Given it's family, Susan, luckily, is comfortable asking for the loan. Her brother-in-law is willing and tells her to pay it back when the big orders come in. Well, Susan had a good first year, but didn't make any payments. Her second year was so-so and fast on the decline. By year three, she was seeing lots of red and filing for bankruptcy protection.

Three hundred miles away, Susan's brother-in-law grew increasingly restless. Months and then years went by with no attempts made to repay. Calls, messages, letters. Threats. Lots of 'sorry, I'll put something in the mail,' 'the next order is big,' or 'hey, you know me, I'm good for it.' Tensions flared, Susan, her sister and her brother-in-law were all up in arms.

Susan closed up shop and took off for Japan and hasn't been in contact since.

There's no doubt about it—borrowing money from friends and relatives is always risky. Yet, there are over seven million outstanding loans between individuals outstanding at any given time in the US, according to the Federal Reserve Board. Most small business owners rely on funding from friends and family mainly because it is relatively inexpensive and available.

If you are borrowing money from or lending money to friends and relatives, these five tips will get you on the right track.

1. Document the loan terms
Handshakes are never enough. Relationships can be ruined due to misunderstandings about loan terms. If you don't write down the terms in a promissory note, future investors and creditors will also be wary.

2. Use a fair interest rate
Lenders will be much happier about forgiving payments now and then if they feel that the interest rate is fair. The IRS has strong opinions about no-interest loans among family members.

3. Avoid balloon payments
Balloon payments or lump-sum payments at the end of the loan term are very risky for both borrower and lender. Borrowers inevitably cannot save enough to make the balloon payment and lenders inevitably cannot tolerate renegotiating the loan at the end of the term.

4. Remember the tax benefits
It is tempting to avoid formalizing loans among friends and relatives, but there are tax benefits to using a formal promissory note. If the borrower cannot pay back the full loan amount, the lender is entitled to a tax deduction as "bad debt"—but only if the loan was formalized.

5. Enjoy the flexibility
The ability to change loan terms, make an occasional late payment, and react to the changing life circumstances makes flexibility the bedrock of loans among friends and relatives.

Used with permission: CircleLending, the nation's leading loan administration platform for interpersonal lending, helps individuals create and manage loans among friends, relatives and community organizations.