Lending money, especially to relatives and friends, is a common practice. There are two main reasons for lending money: one, to bail friends and family members out of financial stress, and two, to earn interest income. However, it’s a fact that many people lend money to their near-and-dear ones without charging any interest whatsoever.
But, personal relations aside, lending money can also be a delicate situation that needs to be tactfully handled. Any laxity on the borrower’s side can easily jeopardise relationships. On the other hand, lending money when you can’t afford it can adversely impact your financial health.
We discuss some critical pointers that must be considered while lending money.
It’s okay to say no when you can’t afford to lend
This is very important. You must have your own house in order to be able to help others. So, the next time a friend or a colleague asks for monetary help, don’t rush into a decision. First, check your bank balance and liquidity situation before saying yes. Closely evaluate the fact that you might have to withdraw from your emergency fund or liquidate your investment returns to accommodate the request — things that can put a speed breaker in your journey to meet your financial goals on time. So, if you think you can’t afford to lend at the moment, it’s perfectly fine if you politely decline their request.
Try to find out why your friend or relative cannot get a bank loan
Does your friend or relative have a poor credit score owing to which he/she cannot apply for a loan from a bank or a financial institution? It’s a fact that credit scores take possibly the hardest hit when someone defaults on a loan or doesn’t pay the credit card bills, things that should certainly raise a red flag if you’re looking to lend money to them.
Also, it’s not uncommon for people to ask others to take a personal loan on their behalf promising they’ll repay the instalments every month that can be transferred to the bank. You’ll be well-advised never to consider such a risky request as you’ll be in the bank’s firing line if your friend doesn’t pay up on time. Inviting major financial troubles because of someone else’s carelessness isn’t worth it, is it?
See whether it’s feasible to add an interest component in the loan package
Based on the kind of relationship and the level of trust you share with your friend, you may want to add an interest component in the loan package that you offer to them. If the borrower is regular with repayments, you can actually earn some interest income out of the money you lend which can boost your financial well-being. And if you want to include an interest component, you can consider average fixed deposit rates (about 6.5-7%) or personal loan rates (about 16.5%) as the benchmarks to ascertain the applicable interest on the loan you offer.
Take steps to safeguard your financial interests
Unless you’re giving a financial gift for which you don’t expect any repayment, you’d rather be well-advised to take some steps to safeguard your financial interests while giving a loan. The best practice is to get the terms and conditions of lending written on a legal paper. This will come to your rescue if there’s any dispute in the future.
There are two ways to get the terms and conditions in writing. You can get a promissory note from the borrower who needs to confirm the receipt of the loan money and agreeing to the conditions attached. Another option is signing a loan agreement by both the lender and the borrower. The loan agreement should consist of all the terms and conditions such as EMIs, interest rate, tenure, default, termination clause, etc. Lend money by giving payment in cheque or through online transfer and mention the cheque number or the transaction reference number in the loan agreement.
You can also consider getting post-dated EMI cheques from the borrower to ensure timely payments and for the security of your money.
These steps will go a long way to stabilize your finances while lending money, and also prevent relationships from getting strained. Also, it makes sense to educate a close friend or a relative who is careless with money about wise financial management habits to prevent them from falling into a debt trap. Tell them the importance of having in place an emergency fund (consisting of at least 6 months’ expenses) and a comprehensive health insurance policy because most often people are forced to seek loans when their savings get drained while tackling a medical emergency.
Also, closely monitor the financial health of all your immediate family members and try to assess if any of them may require financial help from you in future. And apart from educating them on money matters, you can also consider increasing your emergency fund, or even starting a separate mutual fund SIP, so that you’ll be in a better position to help them in need. However, the selection of your mutual fund should be in line with your risk profile, and while you can redeem it quickly, you need to factor in the exit-load charges for the same too.
In conclusion, we understand you want to help your friends and relatives to tackle a difficult financial situation by lending them money. But that doesn’t mean you undermine your own financial health in the process. The key lies in striking a balance.
The writer is CEO, Bankbazaar.com