4 myths about lending money to friends (based on actual research)

There are a lot of "experts" out there who tell you the rights and wrongs of lending money to friends and family. They're awesome at creating numbered lists. But they're not great at looking at evidence. So we decided to write one based off of actual evidence. I included the numbered list part though :)

Bloggers or anyone with $1 in their pocket will say you should just say no (without any real justification) or give a laundry lists of all the things that could go wrong. But can it go right? Is there a more nuanced and sophisticated answer than just say no? Is there a way to set it up for success? What if we took that cynical approach to everything we did? We investigated…

[Full disclosure, we took all our research and experience lending to friends and family and built a platform out of it: www.HiFrank.com. It's free. It takes all the best practices and makes them easy.]

Here are the biggest myths (and real solutions).

Myth 1: Sign a Contract!

You see this one over and over again. Everyone says you should sign a contract. That's not the best answer.

There is some evidence that contracts can be helpful. Researchers from Harvard have shown that even a handshake agreement between people can increase the odds of cooperative behavior (e.g., your friend paying you back) by aligning expectations.

But there is strong evidence from researchers at Stanford that the value of an enforceable legal contract between friends is actually zero, especially if you're close friends. Are you really going to sue your friend?

This is in addition to the seminal research from Falk and Kosfeld that shows that if someone chooses not to regulate other people's actions (i.e., don't make them sign a contract), the others will be extra nice to them (i.e., pay them back more). Turns out asking them to sign a contract is a signal of distrust, which then makes the borrowers care less about acting in a trustworthy way

So if aligning expectations is good but signing a contract is bad, then what's the right answer?

The best approach is to align on expectations without the awkwardness or transactional signaling of making a friend sign a contract.

There's lots of ways to do this. At Frank we show both lenders and borrowers (on average) how much money their friends borrow, when they pay it back and how much interest they pay before a lender lends or a borrower borrows. It's a powerful way to align expectations, without the negative signaling of a contract.

Myth 2: You friends won't pay you back so be ready to chase them down (or make it a gift)!

This is definitely a challenge. When someone borrows money they almost always intend to pay the money back. But sometimes things come up or circumstances change or it just starts to seem like less of a priority.

But it's completely wrong to suggest that you'll always have to chase them down. You just have to set up the right system. The trick is to set a commitment mechanism that captures all that good feeling at the time of the loan and make that the default option. That way you won't end up chasing your friends down.

Ernst Fehr (and others) have definitively shown that reciprocity is real: people respond with kindness and favor if other people act that way to begin with. So when you lend your friend or family member that money, they have real positive feelings and intend to pay you back (and more!).

The hard part is that reciprocity starts to wane as you get farther and farther from that initial act of kindness. As researchers at UCSD and the University of Chicago show that reciprocal kindness can diminish quickly. So that nephew you lent $1500 to 8 months ago (and who intended to pay you back) might not remember or want to go through all the work to pay you back 8 months later.

But what if you could take that good feeling at the start and make it last? One mechanism is a contract, but we detailed above why that's not really a good idea between friends. At Frank we came up with a different solution.

At Frank, the borrower decides what kind of repayment schedule they want to use at the moment they take the money out AND they authorize automatic withdrawals from their bank account according to that schedule.

It's a simple way to capture the good feeling that exists at the initial moment and makes sure it's not lost (without the awkwardness of a contract between friends).

The lender doesn't have to chase the borrower down, the borrower doesn't have to remember to pay the lender back, and the spirit of that initial feeling is maintained for months — so you don't have to chase down a friend.

A simple and easy solution to an old myth.

Myth 3: It's a bad investment!

We hear over and over that it's a terrible investment. Turns out that doesn't have to be true either.

Right off the bat, different people value different things differently. For instance some people get an enormous amount of personal satisfaction from helping a friend out and don't care about the financial upside. That is absolutely true, but we'll even just focus just on the financial piece here (since that's what others like to focus on).

It's only a terrible financial investment if you execute it terribly. If you just hand out the money without any thought about who you're lending to, it might go bad. If you don't have any alignment on expectations with borrowers, it might go bad. But if you properly structure the interaction then the investment side will likely be great. The key is a structure that reduces defaults and includes interest.

The first critical piece is reducing defaults. At Frank we do this two ways: (1) by making sure there is strong social capital between the borrower and lenders, and (2) making repayments easy. We covered the second point in Myth 2 so we'll focus on the first point here.

By only lending money to people you have deep social connections with, lenders reduce defaults by removing people they have good information on and suspect won't be able to pay them back, and by leveraging the social capital between them. As the researchers at Stanford pointed out, dense social networks (e.g., close friends) are much more likely to pay you back because of the social costs of not doing so.

The second critical piece is including interest. Making money off friends can be a super touchy subject and negotiating an interest rate with a friend seems like a good way to commit social suicide. But what if there was a way to include interest without all the taboos? That's the key to making this a good (financial) investment.

At Frank we use a pay what you want model where borrowers are free to pay as much or as little interest as they want. We show the borrowers how much interest their friends pay and let them decide for themselves. Most are happy to thank their friends with a little extra (especially because they decide at the moment it happens — strong reciprocity!). It's an easy way to let the borrowers thank you for lending them the money, without all the awkwardness of negotiating interest. And it's an important way to show the conventional wisdom folks they're wrong to say it's always a bad investment.

Myth 4: NEVER lend money to a friend

This is probably the biggest myth. It's hard to show evidence to just straight up prove this wrong (Frank is well on it's way though). But it you look at the other pieces of conventional wisdom we've identified you probably get our point.

There are lots and lots and lots of times you SHOULD absolutely lend money to a friend or family member. Just do it with the right structure.

Because when you do you can feel good about helping those close to you, save them some money and make some money for yourself.

Frank can help!

www.HiFrank.com

Frank: D'Arcy

Read more posts by this author.

Subscribe to The Frank Blog

Get the latest posts delivered right to your inbox.

or subscribe via RSS with Feedly!