Loans involving family and friends can jeopardize relationships

Loans involving family and friends can jeopardize relationships

A friend in need is a friend indeed, but personal relationships can be jeopardized by borrowing money from or lending money to people you care about.

In what is believed to be the first academic study of its kind, researchers at Carnegie Mellon University found empirical backing for the ancient proverbs and other words of wisdom handed down throughout the ages that caution against lending money to a friend.

The biggest risk of loaning money to a friend is not the loss of the money, but the potential loss of a relationship between the borrower and the lender, said George Loewenstein, a professor of psychology and economics at CMU Dietrich College of Humanities and Social Sciences.

Mr. Loewenstein and Linda Dezso, a Hungarian student who was studying at CMU on a Fulbright scholarship, investigated the complexities and consequences of personal loans between friends and family. They asked 971 individuals to complete a detailed survey on personal loans they had made or received within the past five years, including the size of the loan, its purpose, the amount repaid, whether interest was charged, if a formal contract was involved and the relationship and history between the borrower and lender.

Two main findings emerged from the yearlong study recently published in Journal of Economic Psychology.

The researchers found borrowers had selfserving biases when it comes to personal loans. They are more likely to believe the loan was initiated by the lender and that the loan had been paid off as agreed. If the loan was delinquent, they were inclined to feel it was a gift.

The second finding was that personal loans that had not been paid off and were overdue resulted in wideranging negative consequences, such as loss of closeness, loss of trust and lenders feeling that the delinquent borrowers were going out of their way to avoid them.

Strangely enough, when borrowers don repay loans, they don feel disturbed. They forget about it, Mr. Loewenstein said. The lender feels the borrower is avoiding them and the borrower is blithely unaware of the thoughts and feeling aroused in the lender.

The divergent reactions to a personal loan over time can result in a breakup in a relationship.

The idea for the study grew out of a brainstorming session between Mr. Loewenstein and Ms. Dezso as they tossed around ideas for her dissertation. She mentioned a loan she made to a friend that went bad, and that led them both to recall other instances of not being repaid.

Then it occurred to them that maybe they were having trouble remembering loans they had received from friends and family that they had not repaid.

Immediately after receiving the loan, the borrower is generally grateful and has every intention of repaying the loan, Mr. Loewenstein said. The lender usually feels good about it, too. But as time passes, feelings change.

The borrower very often forgets about the loan or believes they have paid off more than they actually had. And the initial gratitude is often replaced with amnesia and even sometimes resentment. On the lender side, the initial good feelings can give way to distrust and anxiety about repayment.

The CMU study assumed that the personal loans generally ranged from $10 to several thousand dollars.

But sometimes friends entrust other friends, family members and coworkers with much larger sums.

Kate Byrne, a senior wealth planner at PNC Wealth Management, Downtown, said there can be tax consequences for people who make personal loans greater than $10,000.

Be aware of IRS rules for loans to a family member or friend that total over $10,000, she said. If the rules aren followed, a lender may expose themselves to additional income and gift taxes.

The Internal Revenue Service also requires lenders to set an interest rate depending on the pay back period. For loans less than three years in duration, the minimum rate is 0.24 percent. Loans between three and nine years have a minimum rate of 0.92 percent. Loans lasting more than nine years must charge an interest rate of at least 2.3 percent.

Ms. Byrne said if the required minimum interest rate isn charged, the IRS will treat the loan as if the borrower paid the interest and the lender will have to include the income on his tax return. The IRS could also assume the lender made a gift of the interest back to the borrower, which could potentially cause the lender to pay a gift tax.

She also suggests documenting personal loans between friends and family members with a written contract that spells out the terms. It should be signed by both parties and witnessed by two other people just in case the lender needs to ask a local magistrate to help collect what is owed.

By the time it gets to that point, you are probably not having lunch together or going out for beers after work anymore, Ms. Byrne said. The idea is to structure the loan similar to an arm length transaction between unrelated parties. The IRS rules are in place to prevent wealthy individuals from making loans to family members in lower tax brackets.

Ms.

Mr. Loewenstein said he not against friends and family members making personal loans to each other. But they should never lend money they can afford to lose, and they should think hard about the risk of losing a friend as well.

People are awfully generous when making personal loans, he said. We get caught up in the heat of the moment. We sympathize with the person who needs money and don think enough about the possible adverse consequences of making the loan.

The moral here is not that you shouldn loan money. In the best of circumstances, personal loans can reinforce a relationship. But as you do with all important decisions, sleep on it and consider the possible consequences of making a personal loan.