How to protect yourself if you lend money to family

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Should you lend money to family members? It is a question most of us will face at some point, and we don’t always respond rationally.

“You think you’re going to get your money back from your relatives because you hate to think they’re going to stiff you,” said a former client of mine, whose business I helped sell.

He should know. Several years ago, he lent a nephew $20,000 in two installments so he could expand his marketing agency. While he received a few payments early on, they soon came to an end and he hasn’t received a dime in recent years.

On another occasion he lent a different nephew $33,000 to open a coffee shop, and, so far, he’s pleased to be receiving interest payments every month. As part of the loan terms, he also has an equity stake in the business.

He says he hopes to get his money back in both cases but admits that “it was money that, as I lent it, I knew that I may not ever see it again.”

It’s not just this former client. The issue keeps coming up.

While it is great seeing family members, you may hear about Aunt Jill’s unemployment or Cousin Ben’s struggling sales career. Their pleas for financial help will tug at your heartstrings and you may want to help out, but there are precautions you should take before lending money to relatives.

Set terms

Just because it’s a loan to a family member doesn’t mean you should treat it casually. You should spell out all the details in a written agreement (the terms of the loan, how it will be paid back, and the interest rate).

What you may not realize is that if you aren’t charging interest, you are making a taxable gift of the interest that you waived. To avoid that issue, consider charging the monthly banking lending rates, published monthly by the Canada Revenue Agency, and reporting these transactions to the CRA.

Ask your accountant about tax implications.

Prepare to get stiffed

People often go to family members for loans because they want more lenient terms than they would get from a bank, which aren’t easy to stiff without legal consequences. As a lender, you also don’t want to risk permanently fracturing a relationship over a few thousand dollars.

If you’re lending money to a family member, you should probably go in thinking that you’re not going to get paid back. A relationship will be a lot better off in the end if you go in with that expectation. If you do get the money back, so much the better.

Don’t lose your shirt

While you may be a generous person, you shouldn’t give a proverbial blank check to your relative. Any cash you lend should be money you can afford not to get back. You also shouldn’t keep your spouse in the dark on a family loan.

The bigger the amount is, the more important the agreement from your spouse, because if it doesn’t get repaid, it’s going to impact them as well.

If your loans to relatives are hurting you financially and they ask for money again, you can explain your predicament by saying, “I know that I’ve done this for you in the past, but I cannot do this for you any more because I am putting myself in jeopardy financially by continuing to help you with these multiple, multiple transactions.”

Don’t be an enabler

If your relative is coming back to you for a loan every few months, your financial support may not be helping them get on their own feet.

If you’re thinking of lending money to a relative, you shouldn’t feel obligated to just because it’s a relative, especially if the relative is a spendthrift.

You should act like a banker and do some due diligence: Ask what the money is for and how the borrower plans to repay it.

If you have a relative and you don’t approve of what they’re asking for or feel that it will enable irresponsible behavior, you should think twice about extending money to them.

My former client agrees: “Obviously, if the same people who owe me money want some more money, and don’t attempt to pay me back, I won’t give it to them.”

Remember, the cost to you of an unpaid loan isn’t just the principal; it’s the principal plus what you could have earned with the money had you invested it elsewhere.

The bigger the loan and the longer it goes unpaid, the bigger the opportunity cost. Example: the $20,000 you “loan” to a wayward sibling when you are, say, 35, would be worth more than $300,000 by the time you’re 65 if invested in stocks that earn just average returns.

Mark Borkowski is president of Mercantile Mergers & Acquisitions Corp., a Toronto-based mid-market M&A intermediary firm. In this capacity he has spoken to many business owners who have faced this issue, as well as financial professionals who have offered advice about how to handle it.

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