Lending money to friend is risky

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Your Money

July 31, 2005|By CAROLYN BIGDA

WOULD YOU risk a pound of flesh to secure a loan for a friend?

Though such gruesome collateral is the stuff of Shakespeare, mixing money and friendship often leads to disastrous results.

Even with the best of intentions - perhaps a friend doesn't have sufficient credit history for a traditional loan - you might be putting more at risk than you would like.

When friend becomes debtor: A loan is a contract, with rules for when and how the debt will be repaid. But when friends lend money, there's often a conflict over whether this formal arrangement applies.

"The debtor may want the friendship rules, and the lender, in order to feel like he's not being taken advantage of, wants the creditor/debtor rules," said Chris Long, a fee-only financial adviser in Chicago.

To set it straight, write down the loan's terms in advance, such as when payments are due and how much will be paid.

But financial advisers caution that you should not lend the money unless you can afford to lose it: Unemployment or illness could sidetrack your friend, regardless of written rules.

And "if the debtor can't pay, they're not likely to admit that or be upfront about it because they're ashamed," Long said. As a result, you could lose not only the money, but your friendship.

Loan versus gift: In 2002, an informal survey on DebtSmart. com showed that 27 percent of those who lent money to friends were paid in full. With those odds, you might forgo a loan and give your friend the money.

Gifts up to $11,000 annually are tax free, though there's no limit in some cases, such as paying medical bills or tuition directly to an institution for someone else. (See Internal Revenue Service Publication 950.)

But if you want to lend the money, the IRS says you must charge a reasonable rate (not say, 1 percent) and pay tax on the interest income. Otherwise, the loan will be considered a gift, and taxes could apply to the giver. Similarly, for tax purposes, keep a paper record of every transaction.

Co-signed loans: Stay away from co-signing loans. When you do, you assume the risk that the bank normally accepts.

You become equally liable for the loan's repayment. Late payments show up on your credit report; the loan adds to your debt-to-income ratio; and should your friend stop paying, the lender will come after you.

"The lender will figure you're probably the person with the deeper pockets and can afford to pay this loan," says Dara Duguay, director of Citigroup's Office of Financial Education and author of Please Send Money: A Financial Survival Guide for Young Adults on Their Own. As many as 3 out of 4 co-signers are sought for repayment, according to the Federal Trade Commission.

If you decide to co-sign, ask the lender to agree in writing to notify you if the borrower misses a payment. That way, you can fix a problem before it goes to collections. Also, see if the lender will amend the contract so that you are liable only for the principal and not late charges and other fees.

How to say no: If, understandably, you'd prefer not to lend money, help your friend think of other alternatives. Is there a part-time job he or she could get to raise a little cash? Could you recommend anyone, such as a financial adviser, to call for advice?

E-mail Carolyn Bigda at yourmoney@tribune.com.

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