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How to Lend Money The Smart Way

Has a friend or family member ever asked you for a loan? Or, have you ever considered lending money—perhaps through social lending—in order to earn better returns than you can with your savings account? If so, you have probably worried about the risks involved in lending money. For one, you always risk losing some or all of the money you lend. And, if you lend to family or a friend, you risk letting the loan get in the way of your relationship. But if you’re considering lending money (either to help out somebody you trust or for your own financial gain), there are ways to mitigate your risk and ensure a smooth transaction.

Defining Loans

Loans come in all shapes and sizes. If you’re out to dinner and your best friend forgot his wallet and asks you for $20 to cover his check until you get back to his apartment, you’re making a loan no less than if you lend him $25,000 over five years to start a business. Obviously, we handle small and large loans very differently. You’re not going to hire an attorney to draft a promissory note for $20, but you probably should for $25,000. Chances are you won’t charge interest on that $20 either, although in most cases it would be silly to lend $25,000 without some kind of financial reward. The fact is, a loan does not have to be between a bank and a consumer or business—individuals loan money to each other every day.

Should You Make a Loan?

Deciding to loan your hard-earned money is never easy—specially if somebody close to you is asking. If you’re not comfortable loaning out your money, don’t think twice about saying “no”. It doesn’t mean you don’t care; it just means you don’t feel like running your own bank. If you’re open to the idea of lending money, however, ask yourself the following questions before green-lighting the loan:

  • Can you afford the loan amount without jeopardizing your own emergency fund and cash flow?
  • Do I trust the borrower to repay me?
  • Is the loan being used for something worthwhile?
  • Do I know what I will do if I have trouble collecting the loan?

If you answer “no” to any of those questions, you might not want to make the loan. If you can answer “yes”, however, consider moving forward.

Setting the Terms

The biggest mistake people make when lending money is not being crystal clear about the terms of the loan. How much is the loan for? How (and when) will the borrower repay it? What interest, if any, will be charged? What will happen if the borrower doesn’t pay? You may, for instance, want to ask for something of value as collateral that you can keep in your possession until the loan is repaid (and, if the borrower doesn’t pay, sell for cash).

Finally, always get the terms in writing. Although in most cases the law considers verbal contracts to be valid, they will never stand up in court (should it ever come to that) as well as a written, signed, and witnessed contract—even an informal one.

Lending Money With Social Lending

Even with a solid written contract and collateral in place, a loan between friends or family can still get messy. If the borrower doesn’t repay, one or both parties will hold ill feelings for a long time to come. If, however, you’re looking to lend money as an investment, social lending provides an ideal solution. They vet borrowers based on credit criteria and give you the opportunity to invest small amounts in dozens or hundreds of different loans.

Two leading social lending networks LendingClub and Prosper let you pick and choose which loans to invest in based on their risk level, potential return, and more.

As the recent credit crisis has shown us, lending money is a risky business. Done responsibly, however, lending money can help borrowers achieve their goals faster and individual lenders earn more than they could with traditional investments.

About David Weliver

David Weliver is the founding editor of Money Under 30. He's a cited authority on personal finance and the unique money issues we face during our first two decades as adults. He lives in Maine with his wife and two children.

Comments

  1. When it comes to family or friends I don’t think it is a great idea to ever loan money. Of course if it is an emergency then you should give without the expectation of getting the money back.
    On another note I had never heard about social lending sites that sounds interesting.