Q&A: The hidden cost of lending money to friends and family

Using your emergency fund to help someone else makes little sense, if it depletes your savings to the point that you are at risk if your financial life encounters trouble.

Lending money so someone can make the rent payment, or cover other essential expenses is the very definition of helping someone in need. But lending someone money to buy a nice new car? Or buy a bigger house than they could afford on their own? That seems to cross the line into lending money to help with a want, not a need.

Got a friend or relative who repeatedly has come to you for help? That might be a sign of someone who needs an intervention to take control of overspending, or too heavy a debt load. The National Foundation for Credit Counseling is a nonprofit organization that can connect you with debt counseling organizations.

Yes, you love each other. Yes, there’s nothing you wouldn’t do for each other. That’s not the point. When money is involved, a formal agreement is how you show respect. A simple promissory note might be all you need (a quick web search will lead you to free forms). It should spell out the terms for repayments. Technically you can give any individual $15,000 a year without any tax issues (or $30,000 to a couple). But above those amounts you definitely want to charge interest to stay in the IRS’ good graces, and report the interest as taxable income.

The rate you choose should be no lower than the applicable federal rate (AFR) set monthly by the IRS. Some good news: It’s very low. In May, the AFR for loans with a term of less than three years was 0.25%. For loans running from three to nine years the AFR was 0.58%. The rate is fixed; your borrower keeps paying the initial agreed-upon AFR rate for the life of the loan.

Both costs need to be carefully considered. Sure, you expect to be repaid, but smart risk management involves challenging yourself to consider the consequence of what happens if your assumption is wrong.

Can you afford the consequence of not being repaid?

If you’ve been asked to co-sign a loan, your first thought should be: Hey, why can’t they get the loan on their own?

If they are borrowing just enough to finance a need (say a used car) and yet lack the credit profile to get a good deal on their own, that isn’t cause for alarm. But if they are coming to you because they want to borrow a bigger chunk of money for a want (such as a new car), that’s enabling overspending.

This is especially tricky with college loans.

Kids determined to go to their top choice, regardless of cost, often need to resort to private student loans, rather than stick with federal loans that are safer for a variety of reasons.

Kids can take out federal student loans without a co-signor. But if they want a private student loan from a bank, credit union or online lender, they typically need to bring a co-signor to the table. If you’re asked to co-sign a private college loan, chances are the better move is to suggest your child focus on a more affordable college that can be financed with federal borrowing.

Even if the person you’re helping is great about making timely payments, it’s important to understand that the loan amount is still going to impact your credit score. It’s added to the outstanding credit you have, which will likely cause your debt utilization ratio (DTI) to rise.

If you then need to borrow money for yourself, you may run into a problem where your DTI is too high to qualify, or you will be stuck with a higher interest rate.

Then there’s the other credit score risk: The person you’re helping doesn’t keep up with payments. That means you will need to step in to make the payments. Or be pulled down if there is a default. According to Bankrate.com’s survey, one in five people who co-signed a loan said it hurt their credit scores.