Often I am asked what I think about loans between friends or family. There are usually two reasons where I see this happening, either to help bail someone out of a difficult financial situation or as way for the lender to earn interest, while helping a friend reduce their debt.
If the motive is purely to help someone, top-selling financial author and speaker Dave Ramsey recommends the generous friend consider it a gift and not a loan, and no expectation for re-payment. This is probably good policy, because it helps to maintain the friendship dynamics as much as possible. People should be very careful doing this, in fact before doing so, I recommend reading the book When Helping Hurts for guidance about the best way to go about helping others without hurting them.
Loans between friends for the purpose of debt acceleration and investment purposes goes something like this. Lets say Bob is carrying about $20,000 in credit card debt and the interest rate is 18.99%. Bob is barely able to make the minimum payment, or perhaps is only able to pay a little extra. It may take years for him to get out of debt. Bob’s friend Jim is doing pretty well financially. Jim has more than adequate savings and investments, and his job is secure. Jim would like to help Bob out by loaning Jim $20,000 for debt repayment for 5% for 5 years.
If Bob were paying $400 per month on this credit card, it would take him over 30 years to pay this card off, and Bob would have paid $59,137 in interest. Many credit cards have much higher rates, so this number is fairly conservative.
Jim on the other hand has $20,000 in a 5-year CD at his local bank paying him 1.5%. At the end of 5 years Jim’s CD would appreciate to $21,559. Jim hates this rate of return, and he knows Bob’s predicament, so he approaches him with an idea. If Jim loaned Bob $20,000 and charged him 5% interest, in 56 payments Jim will be re-paid his full $20,000 and earned $2,500 in interest. It was a win for Jim because he earned $1,000 more interest, and a win for Bob because he got out of debt 25 years sooner, and saved over $50,000 in interest.
This sounds like a great idea, but I’m not a big fan of doing so because it can strain the relationship, since the dynamics are never the same, this is the reason Dave Ramsey has the same viewpoint. The other concerns are that if Bob looses his job, or racks up credit cards again, then isn’t able to keep up payments to his friend, then that could strain things. In these types of situations, I recommend that Bob and Jim both speak to trusted advisors that know them both before making this arrangement,. Also, if they decide to go down that path I would insist that Bob attend a Dave Ramsey Financial Peace University class in his area.
There is a third alternative, and that is for Bob to increase his income and reduce expenses so that he has more money to accelerate his debt repayment. Last January I wrote the article 15 Ways to Increase Income; so there may be ways for Bob to come up with extra money to re-pay his credit card quickly. For example if he increased his monthly payment to $600 per month, or $200 additional, it will be repaid it about 46 months. Yes he will pay about $7,600 in interest, but doing it this way will provide character building qualities and give him a sense of accomplishment. If his credit rating is good, he might be able to switch to a lower or no interest rate credit card periodically and reduce the term and interest even more.