5 main pitfalls when you lend money to family/ friends

26 February, 2019

by Kumar Shankar Roy

In our Indian culture, our strength is family & friends. Be it a crisis or a every-day situation that requires financial help, often we end up giving our family and close friends financial help. Like the Reserve Bank of India is for country's financial institutions, our families and friends are our 'financial lender of last resort'.

However, lending money to family and friends has its own share of pitfalls. It may be very difficult to say no to such close people especially when they are in dire need of money. But with no formal arrangement in place regarding repayment, tenure or interest rate, such loans turn bad and can potentially destroy relationships. So, when it comes to lending to family and friends, many prefer the famous adage - neither a borrower, or a lender be.

Still, for those of you considering giving a loan to a dear one, it is important to understand the different challenges that are likely to emerge soon. Let us take you through pitfalls one by one.

1. No agreement

Loans to family and friends are always open-ended and without any formal agreement. This type of situation is bad for both parties. As a lender, you do not have any set expectations. This causes uncertainty and can lead to stress.

Without proper terms and conditions, these loans to family and friend become a free ride. Even, the borrower does not know what the lender is expecting. So, there is bound to mis-communication and misunderstanding.

Most importantly, without an agreement a lender can never ask for money on time. The lender can also not initiate any legal action. Such things can hurt the lender more than the borrower, especially since the money may have some requirement in the future. For instance, a delay in repaying loan by a family member can lead to upsetting a lender's home loan down-payment plans or investment.

In a formal structure like peer to peer lending at a platform like Monexo, things are much simple and efficient. All borrowers are required to provide auto-debits to their bank account for their monthly repayments as per a stated schedule. This makes it easier for everybody --- the lender and the borrower. In case of non-payment, there will be legal actions initiated too from Monexo end for your investment as per legal collection rules.

Lender testimonial: This is why Phani Kumar likes P2P lending at Monexo.

2. You may get only the principal back even when interest rate was promised

Relatives and friends ask money from those of us who are financially better off.

Such borrowers come to family and friends for money for two main reasons. One, they feel you can afford to lend them at very easy and friendly terms. Two, they have no other avenue left when it comes to getting a decent loan. In the latter case, they are desperate. But your money does not come free.

Every single rupee earned by you is due to some hard-work, sacrifices and effort. It was never given to you for no-cost. Still, when relatives or friends ask, many give loans at special rates. However, in cases, no interest is given at all even when promised. All you get, after much haggling, is the principal amount and that too after many years. This is because such borrowers feel that you are rich and dont need any return on your investment. This is not true. When you lend money to someone, you are using a part of your financial resource. So, a standard rate of return is justified.

For instance, if you lend the same amount money, say Rs 1 lakh in a peer to peer lending (P2P) platform, you can get double-digit returns. In case of a p2p platform like Monexo, lenders regularly get 15%+ return per year.

3. No urgency to pay back

With informal loans to family and friends, the borrower naturally may not realize that there is a sense of urgency on the lender's part when it comes getting the loan amount back. Usually, there is no deadline and so no consequence of missing a deadline.

In the real world, even a small delay hits your repayment history and badly impacts your credit score. Without a deadline in family/friend loan, repaying the loan is likely to become the borrower’s very last priority. In short, the borrower even if he is your cousin or a class-mate, has no motivation to repay on time.

Clearly, loans to family and friends are not a smart investment. Even if they have promised to pay you some interest, it is likely to be quite loose-ended when it comes to looking at such a transaction as investing. If you are looking for a fixed income source of returns, you should consider p2p platform

Additional read: How to Get out of Debt and Restructure your Finances

In case of P2P lending, borrowers are given monthly email reminders prior to their payment due date. If the borrower does not transfer money by due date, then reminders are sent by email and phone calls. Many p2p borrowers may endure temporary hardships and this is why they are given a grace period whereby he/she needs to pay latest by the 5th of the month to provision for banking holidays, weekends etc.

In case a peer to peer lending borrower does not repay by the due date, a late payment fee may be charged, and penal interest become applicable. All such norms generate an actual urgency for the borrower to repay early.

Additional read: Should Mutual Fund investors change their strategy and add P2P Lending to portfolio after budget 2019?

4. Awkward meeting at gathering

When you loan money to a family member or a friend, get-togethers become awkward. It may be a small gathering or a large one where others are also present. Giving and taking money makes the relationship strange. You always think when the relative or friend will repay. The family member or friends when she/he looks at you can’t stop thinking about the debt.

All this makes conversations very awkward. You and the person who has taken loan try to avoid each other. Many just smile and head their own ways at gatherings. Such behaviour does not only impact you two, it affects the entire gathering, especially if there are just a few people. In large gatherings, the two can still mingle with others.

Do also note that even normal conversations can lead to problems. For instance, a your friend who has taken loan cannot discuss openly about their next family vacation. This is because you might think if your friend has money to splurge on a holiday, why is he/she not repaying your first!
“Lend money to an enemy, and thou shall gain him, lend money to a friend, and thou will lose him” - Benjamin Franklin

5. Ending relationships with family, friends

While taking money from a known family or friend has its share of advantages, the transaction can harm relationships. In the worst case, the relationship may be permanently destroyed.

People expect you to remain a good friend or family come what may. Truthfully speaking, it is difficult to be good when your relative/friend is not holding their side of the bargain.

The worst outcomes happen when the lender is forced to tell others about the loan to recover the sum. It becomes a matter of pride and prestige. This is very relevant when the borrower and the lender agreed to a secret loan arrangement. If everybody finds out, family status can be impacted. This is one more reason why it is better to take loans from strangers. Familiarity can bring resentment.

In case of P2P lending, the entire borrower and lender relationship is entirely professional and need-based. Unlike lending to family or friends, the p2p borrower does not become a virtual servant to the p2p lender In fact, they will never meet since everthing is online and systematic.

Additional read: How can I grow my money with P2P lending?

Conclusion

For different reasons highlighted above, lending to family and friends should be avoided. Even though you are a good and helpful person, you should try to gently refuse loan requests from your friend or a family member no matter how close they are. From a purely investing perspective, P2P lending offers great benefits and flexibility for all investors.

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