Researchers at Carnegie Mellon University here have found empirical backing for longstanding words of wisdom that caution against lending money to a friend.
"The biggest risk of loaning money to a friend is not the loss of the money, but the potential loss of a relationship between the borrower and the lender," said George Loewenstein, a professor of psychology and economics at CMU's Dietrich College of Humanities and Social Sciences.
Loewenstein and Linda Dezso, a Hungarian who was studying at CMU on a Fulbright scholarship, investigated the complexities of personal loans between friends and family. They asked 971 individuals to complete a detailed survey on personal loans they'd made or received within the past five years, including the size of the loan, its purpose, the amount repaid, whether interest was charged, if a formal contract was involved, and the borrower's and lender's relationship and history.
Two main findings emerged from the yearlong study, with results recently published in the Journal of Economic Psychology.
Borrowers had self-serving biases regarding personal loans, researchers found. They were more likely to believe that the lender initiated the loan and that it had been paid off as agreed. If the loan was delinquent, they were inclined to believe it was a gift.
The second finding was that personal loans that had not been paid off and were overdue caused wide-ranging negative consequences, such as losses of closeness and trust.
"Strangely enough, when borrowers don't repay loans, they don't feel disturbed. They forget about it," Loewenstein said.
"The lender feels the borrower is avoiding them. The divergent reactions to a personal loan" can break up the relationship.
The research idea grew out of a conversation Loewenstein and Dezso had as they tossed around ideas for her dissertation.
Dezso, co-author of the study and now a pre-doctoral candidate at the University of Vienna, mentioned a loan she'd made to a friend that went bad. Both recalled other instances of not being repaid, and realised they had trouble remembering loans they'd received from family and friends that they had not repaid.
Borrowers often forget about the loan or believe they have paid off more than they actually had, Loewenstein said.
"And the initial gratitude is often replaced with amnesia and even sometimes resentment. On the lender's side, the initial good feelings can give way to distrust and anxiety about repayment."
The study assumed personal loans generally ranged from $10 to several thousand dollars.
Kate Byrne, a senior wealth planner at PNC Wealth Management in Pittsburgh, said there could be tax consequences for people making personal loans greater than $10,000.
The US Internal Revenue Service also requires lenders to set an interest rate depending on the payback period. If the required minimum interest rate isn't charged, Byrne said, the IRS will treat the loan as if the borrower paid the interest and the lender will have to include the income on his tax return.
The IRS could also assume the lender made a gift of the interest back to the borrower, which could mean a gift tax for the lender.
Byrne suggests documenting personal loans with a written contract spelling out the terms. It should be signed by both parties and witnessed by two other people.
"The moral here is not that you shouldn't loan money," Loewenstein said. But in making personal loans, you should never lend money you can't afford to lose, and you should think hard about the risk of losing a friend.