Personal Lending and Borrowing is very common and deep-rooted in the Indian Society. We double up as a borrower and lender depending on the situation/circumstances. With economic prosperity and ease of borrowing, personal lending has subdued but still very popular in small cities and towns. The people prefer to borrow from a known person rather than from a bank or financial institution. In many cases, it is compulsion because of low CIBIL Score or under reporting of income in ITR. It means an individual cannot avail credit facility from the bank or financial institution.
Though not 100% relevant but the best example i can quote is of Hindi board in every Shop “Aaj Nakad Kal Udhaar“. In English, it means “It is better to receive Cash Payment today. Tomorrow it will become Borrowing”. Even today i see this board in almost all shops in small cities and towns. In big cities, it is hanging on Grocery Shops :).
To explain the historical importance of personal lending and borrowing, i will share an example of my grandfather. My father told me that when my grandfather shifted from Lahore in undivided India to Delhi under unfortunate circumstances, he only carried his personal diary beside essentials. The diary had all the entries of personal lending to friends, family members, acquaintances etc. He was optimistic that some day he will come back to recover the money from borrowers. Unfortunately, that day never came.
Normally the personal lending is a private affair i.e. among friends, family members, and acquaintances. An individual lend only to the trustworthy people and it is based on mutual trust. We can loosely refer it as Personal Lending. It is another form of Peer to Peer Lending but only among a closed group. On the other hand, Private Lending is an informal lending channel. A new concept of Peer to Peer Lending is gaining traction in online space. It is an extension of personal lending i.e. outside closed group of family and friends.
Why Personal Lending to Family or Friends is RISKY?
A lot of blog readers have shared their personal experiences through the comments section. They regretted their decision to lend to even close friends or family members. In most of the cases, a small amount exchanges hand in the form of CASH. The agreed upon terms and conditions are only verbal commitments. Therefore, from a legal perspective, the terms and conditions of personal lending are legally non-binding and non-enforceable.
Moreover, for a borrower, there is no financial risk or damage in case of delay in repayment or non-payment. The only damage is to the social reputation if the lender decides to take it seriously. The chronic borrowers are immune to such damages. In most of the cases, a payment default results in broken relations, trust, and friendship.
Personal Lending to Family or Friends – 10 Tips to Safeguard your Financial Interest
There are multiple options through which a lender can safeguard his/her financial interest. Let’s discuss
1. Pay through Cheque instead of CASH:
As i shared that this is the biggest mistake of personal lending. A Cash transaction has NO Records. Even if the amount is small, it is advisable to pay through cheque. Personal Lending of up to Rs 20,000 is allowed in CASH. In the case of cash dealing of a higher amount, please be ready for notice from Income Tax department.
2. Execute Loan Agreement:
If the amount is big then it is always advisable to execute the loan agreement. I discussed this point in my post, How to avail Home Loan without CIBIL Score. The mutually agreed upon terms and conditions should be recorded in the agreement. It might be an awkward position to ask friend or family member to execute a loan agreement for personal lending. But always remember that it is your money that is at risk.
The loan agreement is especially required for long term lending. The reason being, if god forbids and if something goes wrong then lender’s money will be lost. In one of the case, Mr. A lent 10L to Mr. B for 12 months. Mr. B died of heart attack after 7 months and family of Mr. B claimed that they are not aware of any such loan. Trust me it is a very common scenario. In such scenarios, a loan agreement can come to the rescue of a lender.
3. Ask for Collateral:
It is very common practice in small cities and towns to ask for collateral against personal lending. The collateral value is equivalent to the loan value. Normally people prefer Gold, Vehicle, Land or House as a collateral depending on the loan value. In the case of vehicle, land or house the original papers are handed over to the lender. Once the loan is repaid, the original papers are returned to the borrower. It safeguards interest in the case of personal lending.
In case, the borrower cannot furnish collateral then you can insist on PDC’s. PDC can also act as a sort of collateral.
4. Purpose of Borrowing:
A lender can always check the purpose of borrowing before lending the money. You should lend only in case the need is urgent and genuine. For example, you should avoid personal lending, if the borrower needs money to repay another loan. It means the borrower is in deep financial crisis. Personal lending for the short-term deficit or in the case of medical emergency is perfectly OK.
5. Period of Personal Lending:
If the purpose of borrowing is for long term or amount is higher then you should always insist on Loan Agreement/Collateral. In the case of short-term lending or small amount, you can go by the verbal commitments.
6. Habitual Borrowers:
You should avoid personal lending to habitual borrowers. It is risky. In some case, these borrowers don’t need money but because of habit they borrow. Habitual borrowers create an ecosystem and lend/borrow frequently to keep money in circulation. If the amount goes out of control then they will find it difficult to manage and not hesitate to default. It becomes a sort of Chit Fund.
7. Interest Income:
Not many lenders are aware that If you are charging interest on loan amount then the interest income is taxable. The interest will be taxed as “income from other sources” as per tax slab of the lender. Therefore do your calculations before personal lending.
8. Interest Payout:
You can always demand monthly payout of loan interest. The reason is not that you are in a need of money but it is a good signal of the “financial distress”. I can conclude from the financial behavior of borrowers that if someone is paying interest regularly and without any delay then the intent is not to default. It shows good credit behavior.
10. Involve 3rd Party:
Last but not the least, you can involve a common acquaintance for personal lending. He will act as a witness and may come to the rescue of the lender in case of default or dispute.
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