Martin Lewis: How best to lend money to family and friends?

And if you’re the person being asked, or offering, to lend a material amount, this guide is for you. It’s about how to do it while minimising the financial and emotional costs. There’s also a template agreement to help, where appropriate.

Equally, if you want to borrow, it’s worth reading this too, as many of the same concepts apply in the reverse. Either way, this isn’t a trivial decision. Below I’ll run through:

1. Is lending right for you?

2. Is it really a loan? Do you need a formal agreement?

3. Can you credit check someone?

4. Should you charge interest? How much? Is it taxable?

5. The ‘lending to family and friends’ template borrower’s agreement

6. How to take action if the money isn’t repaid

1. Is lending really right for you?

The old saying ‘neither a borrower nor a lender be’ exists for a reason. Lending money to someone you know isn’t just a financial decision. It’s an emotional one. It can involve guilt, pressure, love, trust, obligation and - if it goes wrong - resentment.

It’s easy to go into it thinking "This is simple. I give them the money, they pay me back, all is hunky-dory." Yet a better starting point is to ask yourself…

What would happen if it went wrong?

What if they can’t repay? What if they don’t take it seriously? What if your relationship changes? What if the loan quietly becomes the thing you both avoid talking about?

These are best considered now, while you still have a good relationship with the potential borrower, rather than being forced to consider them after the fact, when things can feel sour. And there are more things to add to the pot…

• Never lend if you’re feeling pressured, harassed, manipulated or guilt-tripped into it. Economic abuse is a form of domestic abuse. If someone is trying to control your financial behaviour, that isn’t healthy. This is especially true if they are pushing to borrow in your name for their benefit. There are too many cases where the ‘lender’ ends up with no money back (and often no relationship with the person they lent to), having destroyed their own finances. The charity Surviving Economic Abuse has useful help on this.

• Consider carefully whether you can afford to lend this money. The more desperate your own situation would be if you don’t get the cash back, the less you should be inclined to lend. Even if you do have the money today, think about whether this will impact you, your partner or your future too. Once you lend it, you lose control of it.

• Are there better ways to help, such as debt or budgeting support? While it may feel awkward to discuss this, remember we're talking about someone who is asking you for help. That opens the door to conversations you may not normally broach. If the reason for the loan is that someone is crap with their finances, it’s a gift to point them in the direction of fixing that. You can use the MSE Money Makeover and Budget Help, or if they’re in serious debt, point them to a free debt counselling service.

• Is a cheap form of commercial borrowing a better option for them? Could they carefully use a 0% purchases credit card or get a cheap loan? If those aren’t available now, is that something that could change quite rapidly with some simple credit and affordability work? Use the free MSE Credit Club to assess problems and get help.

• Don't assume if you suddenly need the money in the future you can just demand it all back. If you've agreed a loan, the repayment terms stand. With some close relationships, like your children, you may be doing this because ultimately their needs are your priority, so you’re willing to risk your own financial problems. If that is your situation, then ensure it is an overt, recognised, conscious decision, preferably one you have discussed with the recipient.

• Is this really the right way to solve the problem? Is the money actually going to fix the issue, or, in reality is it more likely just to delay an inevitable full financial crisis – in which case, it may be better for all concerned to deal with that now. Plus, do consider whether this may end up being just being the first request of many. Are you simply getting on a treadmill that will be very tough to get off?

• Is the loan to assist with a mortgage deposit for a home? If so the mortgage lender will usually need to be notified and it can affect affordability scoring (in a similar way to how a commercial loan would). See our mortgage affordability help for more on how it works.

Ultimately, if in doubt, don’t!

2. Is this really a loan? Do you need a formal agreement?

This is actually quite a simple decision. You should use a formal lending agreement if you consider this to be a proper loan. I’d define that as an agreement where you want either or both…

• to be able to take action to recover the money lent if they don’t repay.

• for them to take the loan seriously and repay you, and believe you may take formal action if they don’t repay (even if you know you wouldn’t choose to do so).

If either of these applies, then I’d look at using a formal agreement. The longer the repayment period too, the more I’d lean towards a formal agreement, as relationships can change over time

Ultimately, this decision likely depends on your relationship with the borrower. If it’s someone close to you, who with hand on heart, you'd never take legal action against, and both you and they know it, don’t kid yourself that it’s a loan.

Being honest with yourself about it from the start protects both your finances and the relationship. If that is the situation, the reality is this is a gift you hope they will repay. And if that’s true, you may actually make your life more comfortable and save a relationship breakdown by just giving them the money with no strings attached, or saying, “I’d like you to pay this back only if and when you are in a comfortable position to do so.”

Making a formal agreement

This doesn’t automatically mean a scary legal document full of jargon. It does mean writing down the basics and, at the very least, emailing it across and getting them to reply agreeing the terms. Though, if you’re doing this, I suggest you go the whole hog and use something more formal, like my template agreement below.

Things to consider including are…

• How much is being lent

• Whether interest is being charged and at what rate

• An agreement to share correct information about credit & affordability

• When repayments start

• How much will be repaid and how often

• A final repayment date

• Whether the borrower can repay early without penalty (I’d suggest yes)

• What happens if payments are missed?

• Whether the lender can ask for the money back early (this is very important to consider, if there’s a chance it will happen, both parties need to know it)

• What action may be taken if the loan isn’t repaid

• Signatures, dates and ideally a witness.

This isn’t being cold. It’s being clear.

3. Can you credit check someone you're lending to?

It’s very difficult to do in any formal way. The best you can hope for without extraordinary effort is to ask them to show you their own credit reports voluntarily. Remember, these are sensitive personal documents and you should treat them confidentially and only do it with the borrower’s express permission. See how to get credit files for free. If you’re unfamiliar with what to look for…

- Serious red flags: County Court Judgements, Defaults, Bankruptcy, IVAs, debt relief orders. County Court Judgements and bankruptcy are public record so can be checked for a small fee via TrustOnline.

- Other concerns: High credit card or overdraft use, frequent buy now pay later loans or payday lending, many recent credit applications, or missed and late payments

If that’s all a little confusing, while I’m not generally a fan of relying on credit scores, as they are just one credit reference agency’s view (see how credit scores work guide), for a general overview of someone’s creditworthiness, they’re not a bad prompt (the borrower can get their credit score via the free MSE Credit Club)

Yet, in reality credit scoring isn’t the biggest issue. The key question is "can they afford to repay you?" And that isn’t covered by the credit file, as that doesn't include the most crucial measure in this... someone's income, never mind their expenditure. So you may be lending to someone who's got a great credit score but if they have just lost their job, where the money is coming from to repay you?

So again, as you’re lending this person real money, it isn't inappropriate if you want to ask for evidence they can repay, such as recent payslips, bank statements, rent or mortgage costs and a simple income and outgoings list. You can't and shouldn't force it though if they don't agree, and you should act as if you have a duty of care over their privacy.

4. Should you charge interest? If so, how much?

Many people feel awkward charging interest to family or friends. Yet, in principle at least, that is misplaced. Though, as I'll go on to explain, there are substantial practical problems to doing so.

The reason it's misplaced is that there is a real cost to lending… if you kept the money, you could save it or invest it to make it grow. By lending it, you are giving up that return. The name for this in economics is the ‘opportunity cost’ – or in common parlance, what your money could've otherwise done for you.

Therefore, charging interest isn’t necessarily unkind, ungenerous or unreasonable. But there’s a balance. If the point of lending is to help someone, then charging commercial rates may defeat that. You don’t want to charge them as much as they’d pay on an expensive commercial credit card or loan, otherwise, you’re not really helping them much.

That's the theory, but in practice it's important to understand…

Charging any interest, no matter how small... 1) massively increases the complexity of any loan agreement. 2) means you need to notify the tax office (HMRC) and 3) means you may owe tax on the interest. If all that scares you, just don't charge interest and skip to the next section.

If you're still reading this section, let me try and boil this down for you. The two main issues are

• Any interest received is taxable income (though there may be no tax to pay). If you lend someone £5,000 and want £5,000 back, with no interest or any extras, there is no income tax issue and its nobody’s business but yours.
  
  Yet if you charge any interest, even just to keep pace with inflation, it's by law taxable as income, like savings interest. Taxable doesn’t always mean tax is actually due as it may fall within your savings allowances. For example, basic-rate taxpayers can usually earn up to £1,000 of savings interest a year before paying tax on it (see my four savings tax allowances video for more).
  
  - If you will need to pay tax: If the interest combined with other savings interest is above your taxable allowances for that tax-year, then you should report it in your self-assessment tax return. If you don’t do one, instead notify HMRC via your personal tax account or call it as it won’t know about it otherwise (and not informing it could ultimately be seen as tax evasion).
  
  - If you won't need to pay tax: Even if the interest, combined with any interest from savings isn’t enough for you to pay tax on it in that year, you will need to let the tax office know. HMRC told me:
  
  "Interest earned on money loaned to friends and family is classed as savings income and is taxed and relieved in the normal way. People receiving savings income that is not reported directly to us by the bank or building society should declare this income on their tax return or, if not in Self Assessment, contact us directly to declare it"
  
  And you really don't want to mess with this. If HMRC ever opens an enquiry into your affairs, which it can do relatively randomly, it is likely to ask where money has come from and may want to see supporting documentation. Tax investigations can be extremely time-consuming, stressful and intrusive. HMRC has more powers than the police in some ways. So you’re best to do things by the book, from the outset.
  

• You need to know what interest is paid when. Interest normally “arises” for tax purposes when it is received or made available to you. That sounds simple so far, unfortunately you need to think about what portion of each repayment is repaying the capital (the original amount borrowed) and what is an interest payment.
  
  Most bank loans charge interest only on the outstanding balance, not on the original amount for the whole term. As the amount you owe therefore decreases over time, the interest does too. And working it out can be complex. You'll likely need to use a online calculator to do it.
  

  Very rough rule of thumb…

  For a fixed monthly repayment loan:

  The total interest is usually a little over half of…

  Loan amount × interest % × loan length in years
  
  A worked example:
  
  Take a £5,000 loan at 10% over 5 years, on that the sum above is...
  
  £5,000 x 10% × 5 years = £2,500
  
  Half of that is £1,250 so that's a good estimate (the actual interest using the MSE loans calc is £1,374)

  If the loan is repaid irregularly or just a one off lump sum at the end of the period the interest will need to be calculated carefully. It’s crucial you agree all this before starting, as different calculations can produce very different results.

If you are charging interest, what rate to charge?

Here are a few options to get you thinking on what the right interest rate is for you. If you are going to be paying tax it is worth discussing with your tax advisor if you have one.

• Interest free. Just to reiterate, this is the only simple route. It doesn’t need reporting to HMRC. Yet you will effectively be subsidising the borrower, even if they repay you in full.
  
  This will be suitable for many close family loans, or for short loans where the amount forgone isn’t much (though in that case you could agree upfront that interest starts if it isn’t repaid by the agreed date, but make sure the rate is clear, reasonable and not punitive). It is also the best option if there will be a lot of tax reporting complexity you want to avoid.

• Interest set at the CPI rate of inflation – currently around 3%. This is the ‘little impact to your purchasing power’ route, assuming it is repaid. Inflation is the rate at which prices rise. So, if you lend them enough money to buy 10 shopping trolleys worth of goods at today’s prices, they will repay you enough to buy roughly the same 10 shopping trolleys worth of goods at future prices.
  
  Inflation can be complex to calculate though, as the variable interest will need some working out for tax reporting. The easiest way will be to agree that rather than using the monthly rate, instead you will link it to the annual inflation rate of a set month in the year (this is how the government does it) See the current CPI inflation rate).

• A fixed interest rate based on the top easy access savings rate – currently around 4.5%. This is what you could earn saving the money. So, in a way, you’re still getting what you could have done in complete safety, but with the added risk that they may not repay.
  
  For the borrower this is still far cheaper than they would be able to get a cheap personal loan. I would suggest, for ease, you fix this at the outset. Of course, then there’s a risk savings rates rise so you’re missing out, or they fall so they’re paying a bit much, yet that’s arbitrary so is fair on both sides.

• Pick a simple amount to be borrowed and repaid. For example, if you’re lending someone £5,000 you could say you want £5,300 back total over three years, paid each month.
  
  This is a simple way to do it and that simplicity may appeal even if it isn’t the fairest. Yet do check via the MSE loans calc first to see what the equivalent interest rate you’ve decided on is and how it compares.

5. My lending template agreement

This is a basic starting point, not personal legal advice. I drafted this template letter with input from our in house legal team. It is intended only for one-off simple loans to a between family or friends from a single individual to a single individual (if there’s more than one party it gets far more complicated). If in any doubt get it legally checked.

This is only for simple, loans, if they're more complex they may be subject to consumer credit rules

If you are lending very large sums, lending repeatedly, charging high interest, taking security, lending for business purposes, or taking a charge over property, or anything where the consequences would be serious, there is a risk you will be in breach of consumer credit regulation and the agreement will be invalid. This template is not suitable for those circumstances, and so you must ensure you get proper legal help and a contract drafted up.

6. How to take action if they don't repay

Even if it was a genuine loan and you are willing to enforce it, don’t leap straight to court. While that remedy is available, it should never be the first option…

i. Have a calm conversation. Ask what’s gone wrong. Can they restart payments? Can they pay a smaller amount for now? Is there a realistic date for catching up?

ii. Put the problem in writing. Send a polite email setting out: what was agreed, what has been paid, what has been missed, what is now owed, what you want them to do next.

iii. Offer a revised repayment plan if appropriate. If they can’t pay £300 a month but can pay £100 instead, you may decide that’s better than a family war or a court claim. If you agree a new plan, put that in the same sort of written agreement as above but noting. “This agreement supersedes the previous loan arrangement dated [date]. Both parties agree that the repayment terms below replace the previous terms.”

iv. Consider mediation. If talking directly hasn’t worked consider mediation. An independent mediator is a less aggressive route. They don’t decide who’s right or wrong, they help both sides see if there’s a deal to be done.

For civil money disputes, you can find registered mediators via the professional body Civil Mediation Council) Its fixed-fee scheme currently starts at £75 plus VAT per person for a one-hour phone/video mediation for claims of £5,000 or less, rising with the size of the claim. Both sides normally pay their own share of costs.

It’s worth noting, if you start a small money claim (see below) of £10,000 or less in Eng & Wales, and it is defended, the court will usually tell you to go through a free one-hour telephone mediation (though you will have already paid the court fee).

This can be especially useful where you want to preserve the relationship, or where the borrower accepts they owe the money but can’t currently repay as agreed. What’s said in mediation is usually confidential and shouldn’t be treated as evidence-gathering for court.

If both sides agree a settlement, that agreement can be legally binding. And being able to show you tried mediation may still help demonstrate you made reasonable efforts to resolve things before taking legal action.

v. The Court route: First send a formal letter before claim. Before starting a court claim, you should usually send a formal letter before claim, sometimes called a letter before action. This may just spur someone into action before you actually start the court process.

Don’t leave it too long. Time limits apply. For many simple contract debts in England and Wales, the limitation period is usually six years (it can vary by UK nation), though rules can be complex. This should set out:

Who you are | What you are claiming | How much is owed | How the amount is calculated | What agreement was made | What has gone wrong | What you want the borrower to do | A reasonable deadline for response or payment | That you may start court action if the issue is not resolved.

Keep a copy and proof it was sent. There is more help in our Small Claims Court guide.

vi. The Court route: The start point is the Money Claim online service. Before continuing, take a moment to think whether you really want to do this – start a court case against someone you were friendly enough with to do this type of loan in the first place.

Plus work out whether you think it is a can’t pay or won’t pay situation. Consider whether they actually have income or assets. A judgment against someone with no ability to pay may still leave you out of pocket. You will need to pay a court fee too... though you may be able to claim it back if you win.

If you are convinced to continue, you may be able to make a court claim for money owed. This is often known in common parlance as using the small claims process (though technically cases can always be escalated to higher courts, but in general it shouldn’t be).

In England and Wales, start with GOV.UK’s Make a Money Claim online service, or use the paper N1 form if you can’t claim online. Full help, on that and what to do in Scotland and Northern Ireland is in our small claims guide. Depending on the claim, that may be Civil Money Claims, Money Claim Online or, if you can’t claim online, the paper N1 form.

I hope you find this guide useful. My aim isn't to overcomplicate, but to show you where there are hidden complexities and how to avoid them. Ultimately if you do go through with a loan, the aim is to make it as painless as possible for you and the borrower. Do feedback on your experiences. Martin.