Many of us have faced the sometimes-awkward situation in which a family member or close friend comes to us with hands out, asking for a loan. Maybe it’s just for a fairly small amount, perhaps to buy a pack of cigarettes or put fuel in the car. If that’s the case and you have the cash, perhaps you lend it gladly without giving it a second thought. But if it’s a larger sum and/or the person is a habitual borrower, you might not be so willing to hand it over. And depending upon the dynamics of the relationship, you could be putting that relationship at risk whether or not you agree to the loan. It isn’t an enviable situation.
So what do you do? You have several choices, and they all involve honesty and clear thinking.
Handle with care
Although many relationship experts (as well as everyday people who have learnt their lessons the hard way) strongly advise against loaning money to friends or family, there are no ironclad rules. Helping someone out financially is a personal decision and doesn’t have to end in disaster if you lay down some ground rules from the beginning. Remember that honesty and clear thinking we mentioned above? Here’s where they come in.
As uncomfortable as it may seem given that your relationship with the borrower is a personal one, you may find that the best way to avoid trouble is to approach the loan as a business relationship. Draw up a formal contract if you don’t feel secure about verbal agreements. Remember that this is for your friend’s benefit as well as your own. And if you don’t feel right about loaning the money yourself, help your loved one research other resources, such as peer-to-peer lending or even a credit union.
Enter the guarantor loan
If you don’t have the money or simply don’t feel comfortable just handing over the cash, and the person has exhausted most other resources and doesn’t have good enough credit to get a conventional loan, there is another option to consider: a guarantor loan. This is an arrangement whereby your loved one or friend is the primary borrower but you are the co-signer. That means that if the person is unable to pay back the loan you’ll cover it.
From the perspective of the borrower, guarantor loans can be a good option for those who are trying to build or rebuild credit. It’s not for trivial purchases but rather for larger ones, such as putting a down payment on a car, paying for repairs on a car or major appliance, or even for rental deposits. And unlike payday loans, guarantor loans are generally longer-term; the borrower has up to five years to repay the loan.
However, since guarantor loans are for people with poor credit there are several caveats to consider. Much like payday loans, guarantor loans have come under fire from sources such as the debt charity Citizens Advice, which warned that like payday loans, guarantor loans also carry a substantially higher interest rate than most conventional loans. And many people have signed on as guarantors without fully realising the risk.
Despite the criticism as well as regulatory limitations over the past couple of years, guarantor lenders aren’t faring too badly. For instance the parent group of guarantor lender Amigo Loans saw its profits rise to £36m in 2015, up from £33.5m in 2014. Clearly there is a demand for guarantor loans, and in fact they can be a reasonable option for borrowers and guarantors who enter the agreement with eyes wide open.
Points to consider whether you’re the guarantor or the borrower
Although the legal and business details of a guarantor loan are handled by the lender, both borrower and guarantor need to carefully weigh the decision to enter into such an agreement. For both the prospective borrower and guarantor, the two big factors to consider are trust and affordability. The borrower needs to be certain that he or she can trust the guarantor of course, as asking for money places a person in a position of vulnerability that many people find uncomfortable. But trust is one of those things that works both ways, and the guarantor must be equally able to trust that the borrower will make every effort to pay the loan back on a timely basis.
Affordability is the other major point to consider. A borrower should not try to take on more than he or she is reasonably able to pay back, and of course a guarantor shouldn’t sign any agreement unless certain that he or she will be able to cover the loan should the borrower default. But there is more than financial affordability at stake; both borrower and guarantor should carefully weigh the potential risks to the relationship if the borrower defaults. Is it worth risking a lifelong friendship for the sake of a loan? Both of you need to discuss this and not be afraid to consider worst-case scenarios. This can be challenging when both people have good intentions, but it is necessary.
Lenders also have requirements for guarantors. Many but not all lenders require the guarantor to be a homeowner, and most lenders will only approve guarantors who have very good credit. Prospective borrowers need to keep these requirements in mind before approaching a potential guarantor.
One more point for the prospective guarantor: If the person asking for money is a habitual borrower and you happen to be the person that he or she is always hitting up, that’s a whole separate issue. Sooner or later you are going to have to put your foot down, not just for your own sake but also for the sake of the borrower, who must ultimately assume responsibility for his or her own finances. Sometimes saying “No” seems cruel but is in fact the kindest thing you can do.