What to consider before lending money to loved ones

WEALTH MANAGEMENT

Loaning money to a friend or child may be well-intentioned, but it’s important to consider all the implications, especially in the current context, experts suggest.

The COVID-19 pandemic has wreaked havoc on many Canadians’ finances. By April, 2020 the economy had lost more than three million jobs and the unemployment rate rose to 13 per cent. During stressful financial times like this, it’s inevitable people will turn to loved ones for monetary help. How do you respond to such a request? We asked the experts.

Rule 1: Put yourself first, especially now

According to Doretta Thompson, CPA Canada’s financial literacy leader, the first question you should ask yourself is whether you can afford to lend the money.

“Everyone wants to help their friends and family, but this crisis is hard on us all and that may be a good reason for you to turn them down,” she says. “Who knows what tomorrow will bring? Extending a loan shouldn’t make it difficult for you to make ends meet. Your loved one should start by looking into the many government programs available, including those for small business owners.”

Your primary concern, Thompson says, should be to maintain the cash you need and plan for the worst. “Loans are always risky,” she says. “If a loved one comes to you, you’re probably their last resort, which may mean the risk is even greater.”

CPA Pierre Leblanc, president of bankruptcy trustee firm Groupe Leblanc Syndic, agrees: “Of course you want to help your child, but you shouldn’t sacrifice your retirement plans, for example, to do so. You should be realistic about their ability to pay you back.”

Rule 2: Be prepared to never see your money again

If you can lend money, accept that the loan may become a gift.

“Whatever the amount, make sure you don’t need it in the short- or medium-term … or ever again,” says Leblanc. “The borrower may be trustworthy, but they could get sick, go through a divorce or lose their job. From one day to the next, they may no longer be able to pay you back.”

For your psychological well-being, proceed with caution. “A loan can always be secured, by real estate, for example. But how far are you willing to go to collect? Your goal should be to protect the relationship, even if you never see your money again,” he adds.

In other words, says Thompson, you have to determine whether you’re ready to jeopardize the relationship if the money disappears.

“A parent who lends a child money also needs to consider other family members, like brothers and sisters,” says Leblanc. “For everyone’s sake, the loan shouldn’t be viewed as a debt if the lender dies, but as an advance on the borrower’s inheritance.”

Rule 3: Ask why

Questioning someone you care about and trust to tell you why they need money is awkward but necessary, says Leblanc.

“You have a right to know what you’re getting into,” he says. “You have to consider the risks in order to make an informed decision.”

Thompson agrees. “Close to 40 per cent of Canadians live paycheque to paycheque. They tend to confuse the lifestyle they can afford with the one they would like to have,” she says. “In the current economic conditions, their first step should be to minimize their financial obligations.”

By asking questions, you can understand their circumstances better and may be able to help in other ways, such as buying groceries, housing or babysitting, says Thompson.

“Transparency may not be the norm when it comes to money, but now’s the time to be honest about your situation and the assistance you can offer,” she adds. “This crisis is unprecedented and may lead people to make different decisions than they normally would.”

Rule 4: Set the terms

Under such circumstances, establishing terms for the loan, an IOU of sorts, is essential. Specify the total amount, set a due date or a repayment schedule, and determine whether you’ll be charging interest, even if the rate is nominal.

“Money may still be a taboo topic, but you shouldn’t be shy about asking for information, in the same way a bank would,” says Leblanc. “What’s their current debt level? Do they have a credit report? Can they give you an idea of their actual budget?”

“This is a tough conversation for anyone to have,” acknowledges Thompson. “But you can always say that times are tough for everyone and that you don’t have enough cash.” If you’re honest, your loved one will better understand where you’re coming from and the help you can provide is limited.

“You can also secure a loan by registering an asset as collateral, such as a home or a debt-free vehicle,” says Leblanc. “Or the borrower can name you as an irrevocable beneficiary in a life insurance policy. This makes it possible to protect the loaned amount up front from other creditors, in the event of bankruptcy, for example.”

Rule 5: Think twice before guaranteeing a loan

Guaranteeing a loved one’s loan is just as risky. In addition, you can be on the hook for not only the debt, but also any accrued interest.

“Guarantors feel like they aren’t as involved as if they’d directly provided the funds, but that’s not the case,” says Leblanc. “They take on a new debt obligation if the borrower defaults.”

Some may have their eyes on their parents’ or grandparents’ home equity or other lines of credit and wear them down with emotional blackmail to get what they want. “If you’ve never told them no in the past, it’s difficult to start when money is involved,” says Leblanc.

Under the current conditions, many parents may be tempted to help children whose businesses are in trouble. However, warns Leblanc, “With $10,000, you may be able to put out the fire by paying rent, employee salaries and creditors. But, it’s quite likely that three months from now, business won’t be back to normal in restaurants, for instance. Is this the best way to help? It’s hard to say.”

Decisions like these are all about the numbers and a professional like a CPA or a trustee in bankruptcy can be of assistance. With guidance, lenders will be in a better position to get their money back in the future.