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Seven Rules for Smart Lending

Updated on May 31, 2010

In these hard economic times, conventional institutional lenders have found it far preferable to grab trillions of dollars of bailout money that they received to lend out, and instead keep it for themselves. Nice, huh? Getting a loan is now a far more difficult task than ever before, so many individuals are hitting up family and friends to borrow money that they need for various financial requirements. What do you do when you get hit up for cash?

1. Take a "head and heart" approach. Look at the arrangement with the objectivity of, say, a loan officer, coupled with the sympathy of a friend. If the request you receive seems to be a fair one and strikes an emotional chord, it may be worth taking the chance. If your head and heart agree, you probably won't go wrong helping out. But if one or the other doesn't seem right, you may have a problem.

 2. Consult a third party. Professional advisers such as financial planners and therapists can be valuable in making a decision. For example, if a friend asks for a loan, an impartial third party can offer an unbiased perspective on whether the money actually will solve a problem. You might also want to run the idea by another friend or family member whom you typically turn to for common sense opinions.

3. Don't be skittish about saying no. You should never feel hesitant about turning down someone if the situation carries too many risks. Instead, provide other types of help. For example, if a friend is awash in credit-card debt, offer to try to track down a nonprofit debt counselor. Make it clear that you're saying no to the request but not to the person making it. Find a way to express that your decision is about the money, not your friendship.

4. Think carefully before co-signing for a credit card or a mortgage. Parents sometimes find themselves in a bind when they want to help their college-age kids get their first car loan or credit card. You can be liable for the entire balance if your child can’t keep up the payments. If you want to help them establish credit, tell your kids to apply for a department-store credit card. These cards usually are easy to get, and the amounts typically charged are low enough to keep you from worrying that they'll be unable to make the payments. If you co-sign for your kids’ mortgage and they fail to keep up with the payments, the lender will turn to you to make up the difference. If you'd like to offer a hand, instead give them some cash outright to help cover the down payment. But remind them that the monthly payments are their responsibility.

5. Consider calling your loan a gift. You might let the other person know that, should things change for the better in the future, you would be happy to receive a gift in return someday. Not characterizing the money as a loan can keep your relationship intact if your friend or relative's financial situation worsens.

6. If you want to make a loan, be sure the arrangement is as formal as possible. Draw up a promissory note, establish a payment schedule, and set a reasonable interest rate. The last element can be crucial if you're lending $10,000 or more. If you don't charge the going rate on such a sizable loan, the Internal Revenue Service could consider the money as a gift. Then, you could be liable for gift taxes.

7. Feign poverty. When you get hit up for money, turn it around and ask them for a loan. That one usually works great!

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