Lending money to friends or relatives? Why guaranteeing loans and personal lending can put your finances, credit score, and goals at risk

Last week, a friend called to report that he had been called upon by bankers to make good a loan taken by his brother-in-law. The amount involved was large and this friend has stood in as guarantor in good faith. He could not refuse his wife’s brother. Now, one side of the family looks up to him to support the defaulter, explaining that it was a dire case of hard luck; the other side is upset about misallocating resources to a lost cause when other financial goals of the family need funding. Here is a checklist with respect to lending to friends and family.

You are as good as the borrower

First, guaranteeing someone’s borrowing is as good as being the borrower yourself. Yes, the bank will have recourse to you only if the primary borrower defaults. But the loan then becomes yours to repay, affecting your finances, liabilities, borrowing limits and credit scores. Do not stand in as a guarantor for anyone. In these modern personal loan markets, a guarantee makes the terms of the loan better for the primary borrower, with no benefit to the guarantor.

Second, recognise that you have no control over another’s finances to get involved as lender or guarantor. A bank is able to make loans because it has a thorough process in place to make an assessment. And it has control over assets that will be mortgaged or hypothecated to it. It will sell off the asset and realise the loan if the borrower can’t pay. You, as a personal lender, usually have no such assets that you can control. You may be hesitant to ask for such security from a relative, either.


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Third, if you must guarantee a loan, say an educational loan for your child, ask yourself what you would do if your child fails to repay. Consider that to be a real possibility, even if they assure you that they will repay the loan when they begin to earn. You still have no control over their future earnings. But you may have assets that they may bequeath after your time. Make sure that you have earmarked such assets for the loan if it is not repaid. It may be culturally a tough decision, but it makes financial sense.

Fourth, when a friend or a relative asks you for a personal loan, always seek time. There is no need to feel pressurised to respond immediately. Sometimes, just saying that you will think about it is enough for the other to back off. They may feel hesitant to follow up, or seek others. Take your time to think about why you are being asked for the money. It is fairly easy to get a loan these days with banks and non-banking finance companies (NBFCs) vying to lend to those with good credit worthiness. Propose that you can help them get familiar with such a formal loan process.

Fifth, as a lender you have the right to information. It cannot be that you are obliged to let the borrower save face and not disclose their need and the purpose for which the loan is being used for. Many friends and relatives feel very entitled to the money of others who are better off than them, as if more money came without effort and was a matter of luck. If the money truly came from a lucky situation like a lottery, entitlements go higher. Exercise your right to ask why they money is needed, and allow the borrower to explain convincingly why you should lend. Many fail this test.

Sixth, make some personal rules about the persons and purposes for which you will lend. For example, lending to support the higher education of a meritorious niece is not the same as lending to enable your sister to upgrade her car. You are well within your rights to say that you will not lend to support lifestyle expenses or discretionary expenses of another household. It is your money, and you make the rules about what it will fund.

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Seventh, learn the fine art of saying no. Many of us find the unpopularity that comes with that answer as unacceptable. The borrowers may not scheme or act in bad faith, but may just be using our need to be nice and generous, by reinforcing it through deference and flattery. Many of us fall into the trap of being the generous person we have been portrayed to be. We give in haste and repent in leisure. Or resent the borrower. You can let the borrower know that the money has been set aside for another use.

Eighth, if you do lend to friends and relatives, be aware that you do not have the collection machinery that banks and NBFCs have. You can only appeal to the goodness of the borrower to keep his word. If you are able to persuade the borrower to repay in installments and have the bandwidth to nag them until periodic payments are made, you may be able to lend. But you have no protections or recourse against default by a friend or relative that you have lent to.

Ninth, if you must lend, make sure it is an amount you can mentally write off without impacting your own personal financial goals and investments. You may agree to lend a smaller amount than asked, and desist from saying that you are willing to write it off. You are making a gift; or a charity under pressure. The borrower is unlikely to come back without repaying the earlier outstanding loan. If they do, it is your responsibility to remind them about the dues. Get real about how much you will give and write off. It is a function of both your ability and willingness. Make sure you have ticked both boxes.

Behavioural carelessness

The world is not a bad place filled with people that want to default. It is just that people are behaviourally careless with other people’s money. Without the protection of institutional process and procedure, other people’s money looks too enticing. It is your job to protect your money and not make it easy for someone else to use it as if it is theirs.

The Author is Chairperson, Centre For Investment Education And Learning