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07/07/2011 05:41 pm ET | Updated Sep 06, 2011

Why Loaning Money To Loved Ones Could Be A Financial Mistake

Remember how Wimpy always promised his pal Popeye, "I'll gladly pay you Tuesday for a hamburger today"? So it can go with friends. Promises, promises, promises.

When you're talking hamburgers, reneging may not be such a big deal, but it's another story when hundreds or thousands of dollars are at stake. In these tough times, if you haven't been asked already, just wait: before long, a trusted friend or relative may come looking for help. In a recent survey by Ally Bank, 45 percent of those polled said they had a friend, colleague or family member borrow money from them for an unexpected purchase and unintentionally forget to pay them back.

When you get a cry for help, your immediate response may be to say yes. After all, how can you say no to someone you love, have known forever, and think the world of?

But experts say generosity has its place, just maybe not to good friends and those in the family --- unless done ever so delicately.

JUST SAY NO?

"The best advice is not to make a loan at all," says Simon Singer, a certified financial planner with The Advisor Consulting Group. These transactions can be fraught with danger for your friendship and your finances.

Harrine Freeman, the author How to Get Our of Debt, suggests steeling your nerves. "Don't be a sucker," she cautions. "Don't fall for the tears, sobs and emotional pleas from relatives or friends who do not manage their money wisely."

John Graves, a managing partner at the Renaissance Group investment bank, agrees, and warns against lending too generously. "While keeping wealth in the family can be an ancient wisdom, it must be a respected practice," he says. "

PROCEED WITH CAUTION

It helps to think strategically about lending. Remember that that the person asking for money is likely feeling uncomfortable. Tina Tessina, a psychotherapist and the author of Money, Sex and Kids: Stop Fighting about the Three things That Can Ruin Your Marriage says you should be sensitive, listen and then ask questions. How much is the loan? For what purpose? What is a realistic repayment schedule?

TAKE YOUR TIME

There's no reason to rush your answer. Think it through. Is this an unusual problem, or does your dearheart find themselves frequently in financial difficulty? Even if it's not their fault --- say he or she lost their job or has become ill --- a loan may not be the real cure for the problem, Tessina says. Maybe the larger family or circle of friends needs to get together to provide ongoing support.

If the money is needed to fuel a business, direct them to other alternatives such as government grants, grants from charitable organizations, or raise the idea of them taking on an equity partner. "Try to explain that you want to help, but that lending money to friends and family has high potential to create more problems than such an arrangement might help to solve," Singer says. Let them know you value the relationship and you don't want anything to ruin it, especially money.

Decide in your mind whether this a is a loan or a gift. "Intellectually you can treat it as a gift, as more likely than not, that's what it will turn into if. If you think of it as a gift, then you have a better chance of retaining the relationship with the borrower," says Singer.

Freeman agrees. "When I loan money to family and friends I don't expect to get it back," she says. "I use extra money that I won't miss so I never put myself in a financial burden."

That's key. Make sure you don't jeopardize your own financial health. "Don't go further into debt to help a relative, not even your mother," Freeman cautions. "If you go into debt and lose your job, your mother can no longer get help and you will have mounds of debt with no one to help you." The same goes for tapping your retirement account.

KEEP IT FORMAL

Graves says that you should treat these loans as a business venture. Once you have agreed on the amount of the loan, discuss the interest rate, payment due date, and late fees. To figure out monthly payments, including interest, consider using a loan calculator such as the one at Bankrate, says Gail Cunningham, a spokeswoman for the National Foundation for Credit Counseling. Everything should be in writing. There are online resources, such as the Internet Legal Research group, where you can find promissory note forms for each state. Consider having the documents notarized, as this will give you more legal standing if the borrower defaults, Cunningham says.

There's no question that relationships are at risk with this approach. "I did agree to make a loan and tried to make the transaction as formal as possible. I received loan documents, a semblance of collateral and even an assignment of a life insurance policy," Singer remembers. "At every step along the way, from the request for the loan to the formalization, to the the collateral and life insurance, I was made to feel like I didn't trust the individual. I will never do it again."

But remember, as the banker, you get to call the shots. Kendall Stafford, who owns a small website and graphic design business never "loans" money to family or friends. "I do give them the money they need though. I tell them when they are ready to pay me back, give it to charity or give money to another young person who needs it. The pay it forward concept makes everyone feel good, and they almost always pay it forward sooner than they would pay it back," says Stafford.

PROTECT YOURSELF

You should also be mindful of the possible tax consequences. The IRS frowns on loans that charge little or no interest and may require you to pay a gift tax, Cunningham says. Before loaning more than $10,000, talk to your tax professional to be sure you're protected. If the borrower defaults on the loan, document your attempt at collection so you can write-off the loan.

Consider what will happen if you die before the loan is paid back. In your agreement, include a statement covering such circumstances, says Cunningham. For example, will the loan be forgiven, or will it still be owed to the estate?

If you're told that the money is to pay bills, get the bill and send money directly, advises Freeman.

Ration out help. Don't make helping a habit. "You will only hinder them, instead of helping. Give a man a fish and he eats for a day, teach a man to fish and he eats for a lifetime," she adds. Also anticipate that if word gets out that you are place to turn for cash other relatives will come knocking. Be prepared to deal with the backlash if you don't lend money to all that ask.

And, says Graves, "If you ever hear, 'Mom, you are going to pass away someday and we need the money today,' run for the hills. They are dissing you every time!"