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The Right Way To Borrow Money From Friends and Family
At some point, most entrepreneurs ask themselves: Is there a right way to borrow money from friends and relatives? The answer is “yes.” There are indeed certain things you should say and others you should avoid when seeking loans from friends and family members.
While no one ever wants to rely on someone else to take care of their bills, people will find themselves in this predicament as long as they have higher debts than savings. This applies to businesses as well.
In such situations, taking loans from friends and family may seem like the most reasonable solution. If you plan to ask one of your friends or relatives for a loan, you should prepare to:
We strongly recommend learning if you should get a business loan before asking friends, family, or other lenders for money.
Present Your Case
Avoid doing anything that would paint this loan as a friendly favor. In fact, you want to appear as professional and official as possible. Do the same things you would when applying for a loan from a bank or other qualified lenders. For example, you should:
- Prepare a comprehensive presentation that clearly shows your financial situation and outlines the reasons why they should loan you the money.
- Present your case with the aim to help them understand why you need the money.
- Provide detailed information on how you’ll use the money, the time it will take you to repay them in full, and the amount you’ll pay in interest.
Regardless of how long you’ve known each other or how close you are, keep in mind that no one ever wants to part with their money. The interest should not only act as a motivating factor to help encourage them to lend you the money, but also as a token of your appreciation.
Propose Clear Repayment Terms
When talking to your friend or family member, propose clear repayment terms to this person. This is important because it assures them you’ll repay them.
Here are some tips to follow:
- Convince your relative or friend that paying them back will be your top priority.
- Assure them you’re not like irresponsible friends or family members who may not repay such a debt.
- Outline the repayment start date and when you expect to repay them in full.
- Prove your creditworthiness by sharing your business financials, business plan, etc.
- Put the terms in writing with a clear repayment agreement so your loved one takes you seriously.
In most cases, people who borrow funds from friends or relatives never repay them in full if they repay any of the original amount.
It’s also likely that the friend or family member you intend to approach for the loan previously lent money to a friend or family member who never bothered to refund the amount. Having clear repayment terms not only can help them feel better about lending the money, but also hold you responsible for repaying them over the course of time at certain defined intervals.
Have a Backup Plan
Like everything you do in life, it’s important to have a backup plan because you never know how things will turn out. Don’t make borrowing money from friends and family an exception to this rule.
Here’s how a backup plan can help you secure financing from a friend or family member:
- It demonstrates your professional approach to the loan. Sharing your backup plan with your friend or family member shows you’re thinking ahead just in case, for some reason, you ever fall behind in making a payment.
- It will explain what happens if you miss a payment. Your backup plan should cover the possibility that missing a payment could happen while stressing the unlikelihood of such an event. Show your lender your commitment to making on-time payments by implementing a late fee that increases with each missing payment.
- Offer collateral. Finances are a very tricky subject so you sometimes must give all you’ve got to have a chance. If you see fit, your backup plan could offer collateral to make the deal appear less risky to your loved one. If you have an expensive piece of jewelry, for example, you could use it as collateral.
Create a Written Agreement
You should have a written agreement ready, which explains all the loan details, before you approach your friend or relative. Before your loved one disburses the funds to you, you should both sign the agreement to seal the deal. This is important because it protects both you and your loved one.
Here’s how to create a formal loan agreement:
- Write the agreement in clear, concise language.
- Explain why and how you’ll use the funds.
- Include the loan repayment terms to outline how and when you’ll repay the funds
- Print two copies of the agreement and sign both so each party gets a signed copy.
A written loan agreement offers several key benefits:
- It serves as evidence of all the terms you and your loved one agreed upon.
- It also serves as a formal solution to any conflict that may arise along the way.
- It will help you avoid arguments that could possibly strain your relationship.
Establish Recurring Transfers To Your Lender’s Bank Account
Assure your friend or family member that you’ll set up recurring transfers to their bank account to avoid missing any payments. Beyond that assurance, you should actually do this as soon as possible.
Here’s some options to set up a recurring transfer:
Option 1: Through Your Bank
Another option is to establish an automatic repayment using online bill pay. To do so, you must:
- Sign in to your online bank account.
- Set up automatic bill pay.
- Create an automatic payment schedule for repaying the debt.
- Have your bank send a check each month to your friend or family member.
- Show this setup to your friend or relative to demonstrate you’re serious about repaying them.
Option 2: Using Zelle®
- First, create a Zelle® account. This will let you automatically transfer money for free into your friend’s or family member’s bank account.
- Show this setup to your friend or relative and explain how it works.
Establish your recurring transfers before the first payment is due to ensure you never miss a payment. Most banks allow users to set up recurring payment transfers to another bank account, so it shouldn’t be a problem.
Recommended: Read our review of the best banks for small business if you don’t already have a bank account for your business.
Some Extra Tips: Do’s and Don’ts
As noted above, borrowing money from friends and relatives can prove extremely challenging. But paying them back may be even more challenging — especially if you continue to struggle with your finances.
As you consider borrowing money from a loved one, be sure to follow the do’s and don’ts below.
- Do cut yourself out as a third party.
- Do watch out for social media.
- Do talk to an accountant.
- Do create a repayment agreement.
More About the Do’s
Below is more information about the actions you should consider taking when borrowing money from your friends and relatives. If you’re contemplating lending money to a loved one, some of these points may apply to you as well.
Cut Yourself Out as a Third Party
This rule mainly applies to situations in which you borrow money to pay a bill or a loan. If you want to pay rent or refund money you borrowed from a company or an individual, for example, avoid acting as a middleman.
Instead, connect the person lending you the money to the landlord, company or individual to which you owe a debt for a direct transfer. Doing so protects you from the temptation to spend a portion of the money on other expenses, limiting you from incurring even more debt.
Watch Out for Social Media
Lenders may experience negative feelings when a loved one who still owes them money posts photos or videos of themself in a fancy restaurant or on vacation.
As a result, the relationship might suffer because the lender may feel their loved one isn’t prioritizing their obligation to pay them back.
As the borrower, you need to be aware of this possibility and choose not to have it ruin your relationship with your loved one.
Talk To an Accountant
When borrowing money from friends and family, it’s important to talk to an accountant. An accountant can provide guidance on the tax and legal implications associated with borrowing money from your friend or relative.
If an individual lends more than $15,000 a year to the same person, for example, they must fill out a gift tax return. The same measures don’t apply to the recipient of the money. So, make sure you don’t put your friend or family member in a situation where they could get in trouble.
If you or the person lending money to you doesn’t have adequate financial knowledge, the whole process could become quite confusing. That’s another reason why you should seek the services of an accountant or tax planner to help you understand the requirements of the entire process.
Create a Repayment Agreement
Lending or borrowing money doesn’t have to turn into a bad experience.
You can avoid any drama by establishing and agreeing to deadlines and installment amounts. Draft a repayment agreement that includes all of these details then have both parties sign it and retain a signed copy. This will ensure both parties clearly understand the loan details and expectations.
While a repayment agreement can help to promote a good lending experience, communication makes it even better. You’ll sometimes face financial challenges, and that’s just part of life. The best thing to do is to communicate with your lender about those challenges instead of disappearing on them.
As a borrower, you may face an emergency before the agreed upon date of payment completion. In this case, your best move is to mention it to your lender instead of harboring resentment. The key to a successful agreement is effective communication from both sides.
More About the Don’ts
Below is more information about the things you should expect to happen once you borrow or lend money to a friend or family member. You’ll also find insights on what actions you should avoid to ensure the course of the loan agreement as smoothly as possible.
Don’t Assume Your Relationship Will Remain as Strong Once You Ask for a Loan
Money is a very tricky subject, and borrowing money from a friend or relative could result in a very strained relationship between you — regardless of how close you both were initially. It doesn’t matter if you never miss a payment, something will shift between the two of you and you’ll experience a different energy and may even grow distant with each other.
Don’t Borrow or Lend Money Beyond Your Comfort Zone
Carefully assess your financial situation before requesting a loan to determine how much money you’d feel comfortable having to pay back. If you want to borrow an amount of money you might find challenging to repay, then it’s unwise to borrow it from a friend or relative.
It’s also important to consider your loved one’s financial position before borrowing money from them. They might barely be getting by so lending you money may prevent them from saving for a vacation or retirement. If that’s the case, and if you end up not repaying them, you’ll ultimately trade your short-term financial stress for a long-term relationship strain.
As someone willing to lend money to a loved one, it’s also important to feel comfortable with the amount you lend out. Don’t lend so much money that you’ll only have enough left to barely survive. Ensure you can continue to sustain your normal life even after lending the money. Otherwise, you’ll just start resenting your friend or relative.
Finally, lenders also should keep in mind the real possibility of never getting their money back.
Recommended: Read our Should I Get a Business Loan guide for more information on when to get a business loan.
Don’t Ask a Friend or Relative To Cosign a Loan for You
It’s never a good idea to ask a friend or relative to cosign a loan for you because they’ll be responsible for making any payment you might miss — or risk negatively impacting their credit. Asking someone to cosign a loan for you is a surefire way to hurt your credit, their credit, and your relationship with that person.
Instead of asking someone to cosign a loan for you, consider one of these alternatives:
- Ask for a loan. If the person has good enough credit to cosign, they likely have the money to lend you. This will keep you from paying higher interest rates and protect both of your credit scores.
- Ask a friend or relative to make payments on your behalf. If you find yourself in a financial predicament and can’t make a payment, ask a friend or family member to make the payment for you. This may be an option if they’re unwilling or unable to extend you the full amount of the loan. Once your business starts to earn a good profit, you can then repay that friend or relative.
- Collect a little money from several friends and family members. Family and friends often may face a similar financial situation to you, meaning they don’t have a lot of extra money available to help you. In this case, you can simply ask for a little money from several friends and family members. This approach can help you build trust with several friends and family members, making it far more likely they’ll lend you larger amounts in the future.
The Most Important Tip To Remember
If you choose to borrow money from friends and family members to fund a business, make sure you repay them. It’s important to repay your loan not only to avoid strained relationships, but also because you may need to borrow more money from them in the future.
Here are some other reasons you should always repay the debt:
- You get a lower interest rate. It’s important to provide an incentive to your friend or family member to make it worth their while to loan you the money. So, you should insist on paying them some percentage of interest. But, the interest rate on a loan from a friend or relative can be much lower than a traditional bank loan.
- It’s better to pay interest to a loved one than a bank. This benefits you and your friend or relative, creating a win-win situation for you both.
- You get less strict repayment terms. Borrowing from friends and family members likely means you’ll get better repayment terms than borrowing from a lending institution.