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5 Rules for Lending Money to Friends and Family

By Jeanne Kelly

NEW YORK ( it comes to lending money to family or friends, you've heard the warning: Don't do it! Nevertheless, many of us will be at one end or the other of these loans at some point.

Even financial planners, who have seen how these loans can go well or go terribly wrong for their clients, have lent money to their loved ones and a couple of them offered to share their rules for making these loans work.

1. Make it official.

You can ask the borrower to sign a promissory note spelling out the terms of the loan. This will serve a couple of purposes. For one, it clarifies that you are making a loan, not a gift. Additionally, if the borrower doesn't repay the loan, you always have the option of taking them to court to collect. (Whether you'd want to go to those lengths is another matter we'll discuss in a moment.)

"Create a written agreement with fixed payments at least monthly (i.e., don't 'pay whenever you can')," recommends Cheryl Krueger, a financial planner at Growing Fortunes Financial Partners in Schaumburg, Ill. "Even if the start date is a year down the road, there needs to be some structure," she says.

And don't feel badly about charging interest: you should. "To stay on the right side of the IRS you must charge a minimum rate," says Tom Roberts, a financial planner in Sarasota Florida. Otherwise, the loan could be construed as a gift and may fall under gift tax rules.

One father I know took his daughter to the local courthouse where they recorded a lien against his daughter's vehicle. If she fails to pay him back the money he lent her to buy her car, he can repossess the vehicle. She's definitely taking it seriously.

2. Have a plan.

Roberts suggests lenders set up a repayment plan that matches the terms of the loan to the borrower's circumstances. For example, in a loan to a family member that he was involved with, "we put in a grace period to let her get on her feet and then made the payment schedule match her pay period -- 2 weeks -- to make it more likely to be paid." His story had a happy ending, with the loan paid off early.

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