Just about everybody owes money to somebody at some point.
Look at the average person’s life. They go to college or university, borrowing money for student loans. Then they get out, and need a shiny new car to go with their post-graduation job. So they borrow to buy that. Next comes buying a house, which comes with a massive financial commitment. And throughout it all, many of us struggle with credit card and other debts.
The world runs on debt, especially here in Canada. It’s rare to find someone who is 100% debt free. It’s gotten to the point where we think it’s an accomplishment if someone is debt free besides their mortgage.
Much time and energy is dedicated to helping people get out of debt. Over the years, I’ve seen thousands of tips on how to rid one’s self of debt, with the suggestions ranging from useful to outlandish.
There’s one suggestion I don’t see as often as I should. Many folks should take advantage of borrowing money from their family, especially when paying down high interest debt.
Most people wouldn’t dream of taking this money, saying they’d rather owe a nasty bank than a friendly relative. I’ve never really understood this attitude. Let’s take a closer look at why you should take that loan from your relatives.
The first pro is as simple as it is powerful. A low interest loan from a sympathetic relative will cost you less in the long run.
I know we’re all independent adults who don’t like accepting charity. We want to pay our own way. But your money doesn’t care about any of that. And when it comes to your money, you should take the path of least resistance.
This is especially true when it comes to credit card debt. Cutting an interest rate from 20% to 2% per year is massive. On $5,000 in debt, that’s a difference of $900 per year.
There’s also the flexibility of paying off a relative. If something happens and you fall behind, a relative should be more understanding than the average banker. You’re nothing but a loan number to a big bank.
Borrowing money from a loved one will also give your credit rating a big boost. Credit reporting agencies all agree; if you pay off a debt, your credit score will go up. That will help someone get more loans in the future, although that’s more of a secondary benefit. Too many people get right back into debt after paying off their current loans.
It can also be advantageous to the relative lending the money. They can get a return comparable or higher than other fixed income sources while taking a reasonable risk with someone they know well. And for many people, helping out a loved one in need is a bigger reward than maximizing their investment returns.
How to lend to a loved one
No matter what side of this transaction you’re on, you need to treat it like a business deal. Anyone borrowing money from a loved one should expect to pay interest, make regular payments, and so on. And these terms should be spelled out in a contract.
Many parents feel uncomfortable doing this, preferring to give junior an interest free loan. That’s a bad idea for a couple of reasons. They’re already doing junior a big favor by cutting the interest rate from 20% to 2%. And interest free loans look too much like gifts to me. It’s easy for their offspring to just not pay it back.
There’s an easy way for parents to protect themselves if their child doesn’t pay back the loan. They can simply instruct their estate to deduct the loan balance from junior’s share of the estate. That might seem a little harsh, but remember, the kid didn’t hold up their end of the bargain.
The rule of thumb when it comes to lending to relatives is to write off the loan from the beginning and treat it as a gift. I agree with that mentality. But steps should be taken to ensure the borrower is very aware the loan isn’t a gift.
I see no problem borrowing money from a loved one, especially if you’re drowning in high interest debt. But remember, it isn’t a gift. You should pay back any loan with the same amount of gusto, no matter what the source. That way you can still show your face at Thanksgiving.