Why It’s So Hard to Succeed With Friend or Family Loans

Business.com / Funding / Last Modified: February 22, 2017

Funding your small business through a traditional lending institutions is intimidating, but it's better than accepting a loan from a friend.

Owners of young businesses often have an abundance of ideas and enthusiasm, but a shortage of cash. A loan seems like the most logical answer, right? 

That would be the case if loans were given out like candy, but unfortunately, small business loans are still a challenge to come by. Alternative lending options exist, but those come with downsides too. So, many default to borrowing money from more financially stable friends and family. 

But does a friends and family loan always make sense? Is there any situation that it actually works out for eberyone involved? 

Traditional Loans Offer Few Surprises

Banks and credit unions use (often rigorous) documentation and screening methods to determine a loan applicant’s creditworthiness before agreeing to fund a request. A combination of factors generally influence loan amounts and interest rates. Loan officers examine the amount of a loan, the perceived risk and the potential for future reward beyond interest earnings.

That’s normal business procedure, and it’s pretty transparent. But loans granted on the basis of friendship or family relationships, however, are generally supported by more subjective criteria or a romanticized “happy ending” type reward. Driven by love, trust and faith (maybe even a little swept away with the excitement surrounding the adventure), people may offer the budding entrepreneurs they know help in the form of loans.

The difference of course being one loan is based on evidence and reviewed with objectivity. The other loan is based on emotions, and can bring a whole new dimension to the relationship.

Related Article: Fast Cash: 12 Quick Ways to Raise Some Dough

That’s a Lot of Paperwork

The small business loan application process may take a little fortitude to muster through, a burden you might face while juggling an unfinished business plan or sourcing suppliers while still being in charge of dinner. Your to-do list may feel overwhelming at times.

If you’re one of the 28,443,856 small businesses recognized in a 2015 SBA profile report, much-needed money offered by a well-meaning friend might seem like a lifeboat.

Some Borrowers Don’t Fit the Loan Mold

That lifeboat might start to look like the Coast Guard if your credit situation isn’t quite meeting minimum loan requirements. Maybe you went through a bad divorce or have a gap in your employment history. Or have an indiscretion on your driving record that left you without cash reserves. Are you facing the possibility of being stranded, unable to finance your dream?

You may not be the only one feeling a pinch. Forty-three percent of small business owners participating in a study by the National Small Business Association report lack of access to funds as a major impediment to growing their business.

Friends And Family Loans May Seem Like a Good Idea

As competitive as traditional lending might be, you simply might need to do some due diligence with a few more lenders before you arrive at a suitable loan package. Meanwhile, people close to you may step in with offers of money.

But before you take Aunt Kathy up on her generous offer of help or agree to let your best friend since 7th grade “get you started,” first think it through. Friends and family loans are fraught with potential for heartache and risk.

Sounds counterintuitive, though, doesn’t it? Those closest to you (like Aunt Kathy and your BFF) know you best—what you’re capable of, how hard you work and how much you deserve to succeed.

Much as you might like to imagine bad things won’t happen to your relationship if you borrow from a friend or family member, there’s scientific evidence to suggest you may be wearing rose-colored glasses.

Related Article: No Thanks, Banks: Alternatives to Small Business Loans

What Happens When Friends and Family Become Lenders

In 2012, two professors, George Loewenstein and Linda Dezso, published a study in the Journal of Economic Psychology. The pair found borrowers believe they’ve repaid a higher portion of their loan than they actually have. The abstract of that study goes on to say “...borrowers have a blind spot when it comes to recognizing the negative feelings and perceptions evoked in lenders by delinquent loan repayment.”

There’s often a disconnect between the way a lender (because that’s what Aunt Kathy has become) looks at a loan and the way a borrower looks at a loan.

Don’t forget family lenders also have opinions and needs of their own.

  • What if your aunt or friend suddenly had an emergency that forced them to press you for immediate repayment?
  • Or how about if they suddenly lost their job, which caused them to tighten purse strings that put a halt to a promised installment on the loan, one you were really counting on?
  • What might happen to your relationship if your friend (or relative) didn’t agree with certain spending choices you made with the money from their loan?

Let’s not forget about you. You can’t anticipate what life may throw at you, or the hard decisions you might be forced to make 23 months from now after a loan is in play. If faced with either making a scheduled loan payment or writing a check for the camp your son is dying to attend, what would you do?

Related Article: Fast Cash: 12 Quick Ways to Raise Some Dough

Just Say No to Friends and Family Loans

Instead of accepting help from a friend or family member, you might be better served by clearing up whatever smudges are on your credit or work history. No, it’s probably not going to be super easy or quick to do, or you would’ve done it already. But agreeing to let someone you care for loan you money can add significant stress to your relationship.

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