The Hazards of Personal Loans

money down the drain

When most people think of the word debt, they immediately think of credit cards, auto loans, student loans and mortgages. Those seem to be the most common debts in our society today. But there is another kind of debt that doesn’t get as much attention as the previously mentioned, and that is personal loan debt. This occurs when you borrow money from a friend or family member for whatever reason and vow to pay it back to them at a certain time.

Taking out a personal loan

“Personal loan” is really a technical term. Most people would simply call it “borrowing” and it is usually done with a close friend or family member. A prime example would be a friend or family member that had poor credit, but needs to get a car so that they can get to their job or find work. Due to their bad credit, they might not be able to get a car loan on their own, so they ask for you to lend them money or cosign for the car loan.

personal loans can vary greatly in amount, payoff time, promised payoff time, method of payoff, etc. While credit cards have a pretty standard way of lending people money (the statement arrives with a designated minimum payment and interest is charged if the balance isn’t paid) personal loans depend greatly on who is doing the lending.

The unpredictability of these types of loans is pretty scary. More often than not there is no paperwork drawn up for these kinds of loans and they are only established by word of mouth and banked on trust. However, peoples’ feelings and decisions can be very volatile and someone who lent you money and told you that you could pay it back in 6 months could turn around and demand the money immediately 2 weeks later, which they have every right to do. They can also tell you that they won’t charge you interest and later demand some kind of reconstitution for lending you that money. There are so many unknowns with these kinds of loans that it really makes them dangerous in a way. Extreme cases can end up in court with people battling a loan like this out.

Since these loans are typically from people you know and care about, things can quickly turn ugly if any issue arises. Say you borrow money from a friend and before you pay them back they find out that you bought something that cost a significant amount of money. The person that lent you the money could be resentful that you spent money on something else before paying them back. If you valued a new purchase over paying that person back, it will most likely put a strain on your relationship.

If you promise to pay the money back by a certain date and you are unable to do so, that might also increase tension between you. If you are someone who has a habit of avoiding problems, you would most likely stop calling and communicating with that person so you don’t have to face them about not being able to pay them back. Pretty soon you no longer talking to that person and a relationship has ended because of a small sum of money. Relationships are worth more than any amount of money so you don’t want to let a loan jeopardize that.

I would guess that the major reason people take out personal loans from their friends or family is to cover short term expenses or bills until their next paycheck or source of income arrives. Sometimes bills are due 3 days before a paycheck is deposited or an unexpected car repair comes up. This is what a savings account/emergency fund is for. Unexpected stuff happens and you need to be able to cover yourself until the money you need comes in. If you keep borrowing money from people a) they will most likely start to get irritated with you and b) you won’t learn the importance of saving for the unexpected. Instead of spending seemingly “extra” money on things you don’t need, you should be putting that money into savings for when you don’t have “extra” money (assuming you don’t have a nice savings stash already).

Issuing a person loan

Now that you know why it’s not smart to take out a personal loan, this is why, for the most part, it’s not smart to lend money to others. First of all, this is more directed to those who habitually lend to the same person and not for once-in-a-while circumstances. When you lend money to “habitual borrowers” you are basically bailing them out and preventing them from learning an important financial truth – that you have to save for unexpected expenses (see above paragraph).

Sometimes tough love means having to say no and letting the friend or family member figure out how they are going to get the money they need without borrowing it. In most cases it will be tough and they will struggle and suffer a little, but in the end they will remember that feeling and do what they can to save and not end up in that situation again. If they can always borrow money from you then they will never learn that and saving won’t become a priority to them. This situation most often occurs with parents lending money to children and it can be hard to say no when your child is in need, but it’s important to realize that usually saying no to a temporary need is helping them build a more sound financial future.

This is especially true if lending money to others puts yourself in financial danger. If you use your savings to bail other people out, then what will you use if something unexpected pops up for you? Your own responsibility should enable you to take care of those situations when they happen, but you could be shooting yourself in the foot if you’re too busy taking care of other people’s financial needs instead of taking care of your own.

Personal loans can be a dangerous territory and I urge you to be careful if you decide to venture there on either side. If you do decide that you need to borrow money for whatever reason, I urge you to do that as a last resort and do so very sparingly, as it is not good for your financial health. If you do decide to lend money, I urge you to encourage the person who wants to borrow money to pursue other options first and perhaps help them make a plan to prepare for such unexpected expenses in the future. And on both sides I urge you write down your loan agreement (including amount, payoff time and schedule and any interest charged) and have both parties sign. This will help guard the lender and keep the borrowing accountable to hopefully prevent any negative consquences.

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2 Responses to The Hazards of Personal Loans

  1. Karen says:

    When I was a graduate student, I had a tuition waiver that was suddenly cancelled one semester before I was due to graduate. My graduate advisor “forgot” to tell me until after the deadline for applying for student loans had passed. I had to come up with the tuition within a couple of weeks, or be dropped from the research program.

    I never thought I’d borrow from my family, but I ended up going to one of my aunts for help. (My parents were no longer living then.) She asked me to come up with a budget, and sign a loan agreement (although the terms were pretty loose!). Happily, I graduated a few months later, got a job and paid her back within a year.

    I’m really grateful that she agreed to help, even though it was probably a risky investment for her!

  2. Dehoyos4 says:

    I wrote on this same issue in the personal finance forums. My husband and I did not write out an agreement and we are having to take a loss. We let my brother in-law borrow over $2000 and he has no intentions on paying it back. He has burned a bridge with us. We trusted him but obviously he has no respect and not enough self control over his finances.

    I do everything I can in my family to insure we save enough money every month for a rainy day. I clip coupons ,look for sales, conserve my utilities, ect. It took me a lot of time to save those $2000 and I feel like all that hard work went down the drain. While them on the other hand are what I call “extreme consumers”. Buying everything they want and not necessarily what they need.

    So be careful when lending money and pay close attention to the person’s financial habits.

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