Familiar Finance

People seemed to dig my plan to Get Rich Slowly and declared that not-being-poor is something they plan to do. So, without stepping on any toes or mustaches, it’s time for part 2 of the “Putanumonit pretends to be a financial advice blog” series. To make sure I do this right, let’s first conduct a comprehensive review of the financial advice already on offer by the best sources online.

Weird, one could almost think that financial advice on the internet was sponsored by retail banks. The same banks that only recently replaced family as people main source of financing, and are making a nice profit doing it.

All these articles talk about the downsides of lending or borrowing money from people you know, although mostly in an anecdotal way. What these articles fail to mention, however, are the downsides of not lending and borrowing from people you know. I have an anecdote regarding those as well.

5 years ago, I talked with a business school classmate who owed about $160,000 in student loans. An American with an MBA is practically guaranteed to earn enough to pay that back, but until he does he’s paying 7% annual interest for the pleasure. Meanwhile his parents, both employed and many years from retirement, held a similar amount of money in US treasury bonds which earned them around 2% interest. The difference between the total interest my friend’s family was paying and getting was 5% of $160,000, or $8,000. By not lending money directly to their son, my friend’s family was setting eight thousand dollars on fire every single year.

$8,000 a year is quite a bit of downside.

When I got into business school, my own dad declared that he trusts me more than he trusts the US government, and unlike Uncle Sam I’m not carrying 15 trillion dollars of previous debt either. He said he’s happy to lend me money while I attended school at the prevailing US Treasury rates. What terrible tragedy befell our family for this sacrilege? I borrowed some money, spent it on partying networking, graduated b-school, got a job, and paid my parents back.

People who really like you, for example friends and family, sometimes give you gifts. This fact sometimes confuses people when it comes to lending money to people they like. You can give someone a gift or a loan, but a loan is not a gift. It should be a mutually beneficial investment, with clear terms and no ambiguity. I have a few close friends that if they needed an emergency medical procedure tomorrow, I would gift them any amount they needed if I had it. But if they asked me for a loan to buy a new car, I would charge them interest and set a clear repayment schedule, along with appropriate provisions for early repayment and emergency deferral (if they lose their job for example) .

The main fear of lending money to friends is that in case they can’t repay you would lose both the money and the friendship. If the money was lent as a favor, not repaying favors is an unforgivable sin in friendships. But lending money with interest isn’t a favor, it’s an investment – you make money in return for taking a risk.

You should never lend an amount that you can’t afford to lose, and when you risk your money for profit you should be mentally prepared to lose it at the moment the loan is given. Specifying a clear contract takes the emotion out of it. If my friend can’t pay me back at the time we agreed, I can shrug it off as an unfortunate investment, like buying a stock that went down. It would be reason not to lend them any more money, but not reason to hate them forever.

Conversely, it may seem that charging your friends interest is exploitative. But the loan can only exist when it’s mutually beneficial – if my friend can pay 25% interest on a credit card but I charge them only 5% on the same amount, they’re getting most of the benefit. If my friend had perfect credit and could get a low-interest bank loan, they wouldn’t be asking me for a loan to start with. The reason a friend with a low score can make the loan mutually beneficial is because we have a lot more information about each other than just the credit score, or whatever a bank or credit card would have. This information reduces the risk of lending money, and thus reduces the interest rate required to compensate for the risk.

When someone walks into a bank to ask for a loan, the bank knows very little about them. Are they hardworking? Will they be motivated to repay the loan? What are their spending habits? The bank can’t even assume that they’re dealing with an average customer: adverse selection guarantees that they will get the worst customers that can possibly get through their screening.

With a friend, I’m not worried about that. I know my friend’s habits and plans, and I have a better guess about their motivation to repay me. I also suspect that motivation will be higher than if they dealt with a faceless institution.

Investing in friends also makes you an active contributor in their endeavors. If I lent money to a friend who is in school, I am even more motivated than usual to do whatever I can to support their studies and job search. With a simple loan, you turn a mere friend into an engaged partner.

I had lent to and borrowed money from my parents, friends, and even a girl I dated for four years – she actually sent me the final payment to close the debt a full year after we broke up. Grown ups should be able to handle money arrangements apart from personal arrangements, if they learned how to. When I have kids, I plan to teach them about money, planning and responsibility by opening a savings account at Daddy Bank as soon as they’re old enough to grok what an interest rate means.

So, are Wall Street Journal and the rest of the internet gurus simply wrong? On the contrary: they are almost completely correct.

Lending money within friends and family requires dealing with money in a way that’s honest, transparent, emotionally mature and mathematically sensible. Needless to say, that’s pretty uncommon. I happen to live in a country where weddings cost $26,600, half the population has less than $400 in savings but still buys lottery ticketsvoters support price gouging laws, and instead of being honest about how much they make people waste money on expensive trinkets to signal their wealth to strangers. In this atmosphere of pervasive money-related insanity, keeping money away from personal relationships is the safe move.

But if you’ve stuck around Putanumonit for a while, I hope you’re getting the impression that money is a lot less scary than what the Wall Street Journal makes it out to be. You can invest it well, spend it wisely, even invent your own. And if a friend, a nephew or an ex-girlfriend seem to have a better use for your dollars than you have at the moment, you can probably figure out a way to make everyone better off.

Everyone except the banks, that is.

13 thoughts on “Familiar Finance

  1. I thoroughly agree with this, but fret about the technicalities. Could you share an example contract? I’m not concerned about it standing up in court, so much as covering all the bases in a clear & formal way. (Also, I fear, superstitious(?) enough to think that a contract that I’d written myself would be ‘fake’…)


    1. I’m not sure what you mean by fake other than being legally binding, and I have never written an actual legally binding contract. For loans below $10,000 a lawyer will charge you more than the loan balance to settle it in court, and I’ve only had loans above that amount with my parents. With friends, I recommend sharing the agreement with a group of other friends you both care about, so there’s some social accountability. If one of the two parties is embarrassed to make the loan known publicly, that’s a red flag and a sign that maybe you shouldn’t do the deal.

      The technicalities should be purely about the math, so everyone can agree on the numbers. For example:

      “X has given Y $20,000 on 2/28/2017. Starting 1/1/2018 Y is obligated to send X at least $500 on first of each month, with no upper limit. The balance remaining at the end of each month will accrue 0.4% monthly interest. The entire loan must be paid by 12/31/2027. If Y loses their job, the accumulation of interest and minimal payments will freeze for the duration of Y’s unemployment, for up to 2 years cumulatively. If Y declares personal Chapter 7 bankruptcy in court for outstanding legal debt, the loan is discharged and X receives Y’s collection of signed Britney Spears cassette tapes as compensation.”


        1. I wanted to let you know that I’ve made a couple of loans to loved ones now, and so far it’s been very successful. Doing so also encouraged me to retrospectively write up a contract for another, previously informal, financial agreement, which helped to clarify assumptions and address edge cases.
          It’s enabled me to demonstrate helpfulness, practicality and pragmatism while making me money, which is a pretty sweet deal. Thanks!

          Liked by 1 person

  2. Pretty awesome example of a) a retrospectively obvious analysis that no one else thought of and b) rationality making one a warmer, nicer person.

    If you’re listing the respected authorities you’re contradicting, you ought to include the Bard:

    “Neither a borrower nor a lender be; / For loan oft loses both itself and friend”


    1. Speaking of The Bard, I saw Merchant of Venice as a teenager and instinctively rooted for Shylock. I wish the postscript to the play was:

      “Having demonstrated their lack of respect for contracts and law, Venetian merchants could not finance their risky expeditions and lost their status and wealth to competitors as the city descended into poverty and petty crime.”

      The moral should be: lend to friends and family, not to anti-Semites and crony capitalists.

      Liked by 1 person

  3. I wholeheartedly agree and do this as much as possible (in both directions). But just to play devil’s advocate…

    1. Counterparty risk can be higher than you’d think. There are so many ways that you just can’t ask for the money back without being a jerk. For example, if the borrower has a serious health problem, or, realistically, any of myriad lesser calamities.
    2. There’s also the akrasia problem where the borrower (fully honestly) intends to pay the money “next year” for every value of “next year” for the rest of their life. Not much flakiness is required for that failure mode. Insert Beeminder plug here. For example, in your sample contract, you say “the entire loan must be paid by 2027” but what happens if that deadline is missed? Then you’re on a “one more month/year won’t matter” slippery slope indefinitely. Ie, the borrower is defaulting without it ever being clear that they are.

    You can try to counter those problems with the strategy of “I could lend you this money on the condition that we set up a commitment device such that I eventually get paid back even in the event of calamities that would normally prompt debt relief”.

    What’s really a shame is that the difficulty of pinning down an agreement like that means that often the lender’s best strategy is to just not lend the money. In other words, it would be very much mutually beneficial to make the loan but the cognitive/contractual overhead is too high.

    And as you mention, there’s an adverse selection problem which is especially ironic. If the mutual benefit is huge, like the borrower would otherwise be paying 25% interest on credit card debt, then the perceived risk to the lender is that much higher. Basically, the more desperate the borrower is, the more wary the lender. And the more socially unacceptable it is to charge an interest rate that makes the transaction mutually beneficial.


    1. I fixed the formatting. To create lists you should just be able to just put a period and space after each number, like ‘4. ‘.
      1. Does
      2. This
      3. Work?

      You can also use the “ol” and “li” HTML tags.

      A mitigating factor in lending to friends and family is that at least your money goes to someone whose utility is correlated with yours. If I lend my brother money for a hosue downpayment and then he has a major health issue and loses his job, I’m probably OK with that amount just being a pure gift to help him in tough times (which wouldn’t be true with a stranger or a corporation). Of course, this means that you should never lend more than you can “psychologically” afford to gift, but that’s rule 0 of lending.

      Liked by 1 person

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