Dear Rick:
I have decided to lend a friend some money. I’ve read your columns over the years and I know your thoughts on lending money. I know I should get something in writing but I just feel very uncomfortable to ask for it. This is a very dear friend, and I am willing to accept the consequences if they do not pay me. My friends need $25,000 from me and my question is where best to get the money. My options are to one, take a distribution from my IRA. I am 61 years of age so I’m not worried about the penalty. The second option is to take a home equity loan on my home. I contacted my mortgage company and they told me that my rate would be just under 5 percent. My question to you is what do you think would be the best option? You should know that I am still working, and in one of the higher tax brackets. I also plan to work for about 10 more years. My friend is planning to repay me in about 3 years, and if I do take the home equity loan, I would start making payments immediately.

Thank you.
Larry

Dear Larry:
In reviewing your situation and considering your tax bracket I think the best course of action would be to use a home equity loan. The interest on a home equity loan is tax deductible; therefore, in your situation the money will cost you somewhere in the 3.5 percent range. This is relatively inexpensive money. Then, if your friend does pay you back in a few years, you can take the money and extinguish the home equity loan. Of course the risk with home equity loans is that interest rates are adjustable, and we are in a period of rising interest rates. Therefore, more likely than not, over the next three years your interest rate will rise.

In your particular situation, I’m not a fan of taking a distribution from your retirement account. First, I believe money is sacred and other than in emergency situations, I think the money should only be used for retirement. If you withdraw the money from your retirement account, you would not be able to put it back when your friend repays you; thus, you’re losing out on many years of tax deferred growth. In addition, there is the tax issue. When money comes out of your IRA, it is subject to ordinary income taxes. Considering you are working and in one of the higher tax brackets, the tax hit could be substantial. After all, you’re going to pay federal and state income taxes on this money, and therefore, to loan your friend $25,000 you may have to withdraw upwards of $40,000 from your account.

On the whole, I don’t like to borrow money in order to loan it to someone; however, in the situation at hand I do believe it is the best alternative. Not only does the home equity loan make sense economically, from a tax standpoint, it is a much better way to proceed as well.

I recognize that you understand the risk if your friend does not repay the loan. I also understand how uncomfortable it is sometimes to ask someone to put something in writing. However, what I want to remind you is that putting things in writing helps both parties. The reasoning behind putting things in writing is not because you anticipate going to court or anything of that nature but rather, you want to make sure that there is a meeting of the minds. By putting things in writing you assure that you and your friend are on the same wave length with regard to the loan. In addition, the documentation can cover your backside. If your friend does not pay you back, having the appropriate documentation can help you if for whatever reason things don’t go well with your friend.

Putting things in writing does not mean that you don’t trust the person. After all, you wouldn’t loan someone money that you didn’t trust. It also doesn’t mean that you have to see an attorney. A handwritten note between the two of you may suffice. The key is you want to make sure that both parties understand the transaction and what is expected of both parties.

As I mentioned many times in the past, loaning money to family or friends is admirable, but it is fraught with danger. Particularly for those who loan money and expect it to be repaid, it is extremely important that both sides understand the terms at the beginning of the transaction.

Good luck!

If you would like Rick to respond to your questions, please email Rick at rick@bloomassetmanagement.com