Why We Ignored The Experts and Loaned Money to Family

we’re here today with a post we’ve been hinting at for a while: the full rundown on why we decided to go against conventional wisdom (and the well-grounded advice of many of you!) to make a personal loan to a family member. we wanted to make sure we had everything squared away before sharing the details, but now that time has come. it was definitely not an easy decision, but we took our time making the decision, and now feel good about it. here’s how we decided to make the loan, and the factors that swayed us.

starting from a place of “no”

if you had asked us six months ago if we would ever consider a loan to a family member, we would have responded with a knee-jerk “no.” there are a lot of good reasons not to lend money to someone you have a personal relationship with, but for us, the two biggies are:

1. bringing finances into a personal relationship could change the dynamics, obviously for the worse, and could even affect dynamics beyond the immediate parties involved. that’s never something we would want.
2. you’re unlikely to exercise any real legal recourse if something goes bad with loan repayment (meaning: you aren’t going to sue your relative or friend), which is why most experts say you should consider money loaned out to someone you know to be money you may never get back. we are mostly fans of good investments, not bad investments, especially bad investments that come with hard feelings.

those are hugely important reasons, so to us, there had to be several super compelling reasons why we should make the loan in spite of those risks. and yes, we’ve heard the horror stories, including the ones some of you shared in comments when we mentioned the possibility of this loan. we’ve seen some bad things happen in our own families from financial arrangements that didn’t go as planned, and we’ve never had an urge to repeat those mistakes.

the request

the request for the loan came from a first-degree relative who has accrued some pretty significant credit card debt, and wants to use the loan to pay it off. this credit card debt came not from shopping or from extravagant purchases, but from health care expenses. this person has also shown a real willingness to wise up financially and a sincere eagerness to get out of debt, and is having some legit success with a small business they started. (as a grammarian, using the plural “they” to talk about a singular individual pains me, but we want to protect this person’s privacy, so we don’t want to say “he” or “she.”) but like with most new small businesses, the income stream is not even and predictable, so we’re not positive how a traditional lender would view that.

the philosophical reason to get to “yes”

though our logical sides initially said “no,” there was admittedly a part of me especially that wanted to be able to say “yes,” for one big reason: i benefited from a loan very much like this one about a decade ago. i had some significant credit card debt, and was struggling to make a dent in it, even paying more than the minimum, because of the high interest rates. and, i’ll add, i did not run up that debt paying for legitimate needs like health care and groceries. i ran up that debt buying cocktails and shoes, a new couch i didn’t need, and traveling to date mr. onl during our long-distance year. to this day, i’m thankful that a relative stepped in to bail me out with a loan that let me get out of debt in under three years, something that would not have been possible if i’d been paying the banks directly at 18 or 24 percent interest. so a desire to pay it forward was present in our decision-making, but that wasn’t the only factor that swayed us, not by a long shot.

the deciding factor: security

as it turns out, we were not the first choice to make this loan. the borrower asked some other relatives, who wanted to help and have the assets to do so, but aren’t in a position to free up all the cash needed right this moment for tax reasons. but, they are enthusiastic and trustworthy supporters, and offered up what eventually became the deciding factor for us: security. most personal loans are known as unsecured loans, because there’s no collateral like a house or car to repossess if the borrower defaults. that type of loan is deeply unappealing to us. i’m sure it goes without saying, but we aren’t working our butts off to save for early retirement just to carelessly lend out a somewhat princely sum without any sort of guarantees. but we are actually getting two back-ups as our security on the loan, the combination of which makes us feel good about the loan: those enthusiastic supporters have agreed to be co-signers on the loan, stepping in if the borrower misses a payment or defaults, and we have an extra backup of a guarantee against an estate inheritance. obviously, we never want it to come to that, but it will help us sleep at night knowing that we will ultimately be made whole, even if this whole thing goes down badly.

how we structured the loan

interest rate and term: many of the terms of the loan were proposed by the borrower when they first came to us, including the interest rate. for something like this, it makes sense to have an interest rate that is substantially lower than the credit card lenders charge, but substantially more than a savings account would net, so that it’s mutually beneficial to both the lender and borrower. for this loan, we agreed at an interest rate of 6 percent. six percent is low enough that our borrower will be able to pay us back in five years, but high enough that it will grow our retirement nest egg even if inflation goes up during the repayment years. (and, heck, it’s way more than we’d get from any sort of banking instrument or account right now!) it’s a lower rate than we’d get on a platform like lending club, but those sites don’t often have a lot of loan inventory, and this loan is long enough that we trade a higher interest rate for a more predictable degree of certainty over a longer term.

amortization: when the borrower approached us about making the loan, they proposed a standard, front-loaded amortization schedule, which we appreciate. however, since we’re currently in a high tax bracket, but will be in a much lower bracket after we retire, we didn’t want the biggest chunks of interest taxed highly while we’d be getting much less interest in the years when it would barely be taxed. so we, maybe uniquely among lenders, proposed a schedule in which the interest is evenly distributed over the life of the loan. it’s still the same total amount of interest that the borrower would pay back in a traditional amortization schedule, so if the loan goes until the end, we still end up with the same amount. if the borrower pays us back early, then, sure, we’ve missed out on a little interest, but we can also reinvest that money sooner. so this is another term we’re comfortable with.

proper legal documentation: this one was important to us. we drew up a promissory note using a credible online legal site, and we verified the language with a few other sources to make sure we had a complete contract. the form we used was for a secured loan with guaranty (co-signers), and all parties signed before any money changed hands. in the unlikely event of a default by both our borrower and the co-signers, we want this legally valid contract to demonstrate our claim against the estate which serves as our security. of course, we never plan for it to come to that, but we want to be covered, just in case. and, we included the full amortization table in the promissory note text, should we ever get audited and need to demonstrate that amount of interest payment we’re receiving. (we plan to declare all of the interest on our income tax returns. high income = high audit risk, so this isn’t even a question.)

automatic, scheduled transfers: we don’t want to deal with paper checks, or with somewhat unpredictable payment timing. so just as we insist for the rent we receive from our rental property, we made it a term of the loan that we’ll receive our monthly payments via scheduled, automatic transfers directly into our checking account. and there’s a late fee if it doesn’t happen as scheduled, not that we expect any problems on that front.

the benefits to us of making the loan

though a personal loan was never a part of our financial strategy, and it’s not something we would have chosen to do if we didn’t care a lot about the person we’re lending to, this loan does come with some pretty solid benefits to us:

cash flow in retirement: assuming we work two more years (we’d love for it to be one more, but the markets gave us a good and proper smack down last week, making us less optimistic!), we’ll have three more years of loan repayment after we’re in retirement. our plan while we’re still working is to reinvest the principle and interest payments we receive each month into our vanguard or cash accounts, but after we stop working, the monthly payments can serve as part of our cashflow. this will reduce the amount we have to withdraw from our investment accounts for each of the first three years of our retirement.

guaranteed gains when the market is flat or down: mr. onl tells me that a “poo poo face market” is not a thing, even though i want to call it that. with the markets completely flat in 2015 and in essentially a nosedive so far in 2016, a 6 percent return on a secured loan feels like a pretty sweet deal for us. if you can think of another way to get 6 percent guaranteed right now, please raise your hand, because we sure can’t.

diversification: most of our portfolio is currently invested in the markets one way or another, with a smaller chunk invested in our rental property. this loan gives us some extra diversification for the loan period, and given the current market volatility (or “poo poo faceness”), we’re happy about that.

the hard realities we’ve had to confront

we said it earlier, but we’ll say it again: this has not been an easy decision. we took nearly two months to mull it over after we got the request. we consulted expert opinions on the topic. we had some major heart-to-hearts. we had some tough conversations with our borrower and co-signers. and we’ve accepted some tough realities:

despite our best intentions, it could still hurt relationships. we’ve had multiple long conversations with every combination of people involved, and we’ve tried to head off potential problems. but this could still end up harming a relationship or two. we for sure don’t want that, but we also see a loved one who’s in a tough financial spot, and without help from us or someone like us, they will have a hard time being able to build a positive financial net worth. we want to be part of the solution, and are accepting the risk that comes with that.

we could lose the money. despite vetting the borrower’s income and assets, despite securing trustworthy co-signers and despite having the final backstop guarantee of a share of an inheritance, we could still lose all or part of the amount we’ve loaned out. that’s not the outcome we want, and it’s not an outcome we would accept without trying to work something out, but we’re going into this knowing that it’s a possibility. timing is everything here: knowing we’re ahead of schedule on our early retirement plan, and that we’re likely to go into our retirement with a bigger cushion than we need, gives us the confidence to proceed with the loan. if, in the next two years, we get signals that the loan is shaky, we can keep working a little longer to make up the difference, but it would be quite different if we were being asked to make this loan after we had already quit. in that case, it would be awfully hard to say yes.

so there you have it, friends. 2100 words on our decision to make this loan. now it’s your turn: tell us what you think of our choice. would you make the same decision under the circumstances? think we’re being optimistic idiots? ;-) we’ve heard some stories of negative experiences lending money to family, but anyone have any positive stories to share? anyone else like me in benefiting from a family loan? please share!