I have had this conversation many times with clients and other friends or family members. Some don't like to do business with family members. Others don't want to say no, but are concerned about how to approach it. Whatever your hesitation or lack thereof I think there are a few key points that you should consider.
First, if you are approached remember saying no is always an option. Generally, you are being asked because the person is unable to get a loan from a traditional source such as a bank. As the lender you need to remember that this loan has risk associated with repayment or what we will call default risk. Should you decide that the loan makes sense for you it should be done with a few important points in mind.
1. Get everyone on board.
It is important that your spouse and all parties associated with the deal be clear on the deal. Get everything in writing and signed by all parties. This will avoid future misunderstandings or hurt feelings in the event the loan is not repaid or payments are made more slowly than anticipated.
2. Only lend what you can afford to lose.
This is good advice with any investment, but particularly when dealing with family or friends. The reason most people worry about doing business with a closely related party is that they value the relationship and don't want something like money to come between them. If you go into the transaction with the mindset that this money will likely not be repaid then you can decide how much you are comfortable lending.
3. Keep it professional.
Details of the loan should be in writing. Though it may seem awkward, you have the right to know where the cash you are lending is going. This will help you decide if this is a worthwhile loan. Furthermore, the documents should spell out the exact amount being loaned, a specific repayment schedule, interest rate and possible late fees. Again, this allows all parties to have the protection that there will be no future misunderstandings or hard feelings.
4. Charge interest.
It is critical to remember that an interest rate should be charged. The rate that is selected should be based on the likelihood the money will be repaid, the use of the funds and ultimately the opportunity cost to you of lending these funds to another person. By opportunity cost I am referring to what you may have been able to earn had you invested your money in another manner, such as stocks, bonds or real estate. I suggest you charge a rate that is competitive to other lenders and within IRS guidelines.
5. Communicate regularly.
Remember, if you can't afford to make the loan then do not put yourself in financial distress out of a perceived obligation. However, should the loan be made it is wise to establish open lines of communication and have regular conversations from the beginning. Being proactive rather than waiting for a problem to arise will keep things running much smoother. Maintaining honest and open dialogue regarding the loan will allow them to be honest if they incur repayment problems and you can address it directly together avoiding awkward or dishonest excuses from the borrower.
If you find yourself in this type of situation and are uncertain about how to handle it I suggest you contact a financial professional and discuss your particular situation with them. Having a third party without an emotional investment in the process is almost always beneficial.