Should You Lend Money?

Yes. Both bonds and P2P lending are great ways of diversifying across asset classes and get a good ROI…

Oh wait…

That’s not the topic? I see, wrong title! Let me fix it right away.

Should you lend money to acquaintances, friends, and family?

Instead of rushing to the conclusion (of saying “no”), let me try to justify it. I think that certain criteria should be met if you’re committing to such a risky transaction.

First of all, why you? There are countless ways to get money nowadays… Your friend can go to any loan shark and help himself out.

But yeah… There are 10%+ interest rates…

So here’s where you come in, right? But why? Why should you lose money by not lending to people willing to pay 10% premium and instead give it to someone who wants it for free?

Okay, you’re friends… And even charging 5% is too high for a friend.

Friendship has no price, right?

The price of friendship when lending money

If friendship has no price, it should be reciprocal. I’m afraid you’re not aware of how unidirectional this no-price-friendship is…

Let me explain.

Don’t forget that your friends will return you the exact amount you’ll give them!

Isn’t this a red flag already?

In case you don’t see it, let me illustrate what your friend is robbing you of. For the sake of simplicity, let’s say you lent 10 000$ to your friend and he’ll pay them back next year.

Risk-free rate

This is the rate that you could’ve gotten if you would’ve put your money in a savings account, certificates of deposit, or a simple multi-year bank deposit. These rates aren’t that big, often

Now, if you lent 10000$ to your irresponsible friend, you literally threw away 50$. Why would you do that? He should pay you 50$ for the risk-free interest you’re foregoing by giving the money to him instead of earning more money yourself.

You might feel like it’s not a big amount.

I agree.

So make your buddy pay for it if he wants $10k because you should be covered for any losses you’d suffer by helping him out. Let’s be responsible adults.

By the way, our rate is heavily discounted, as the rate of the 1 year US Treasury bill is currently at 1,57% and used to be more than 2,5% at the beginning of the year.

Current debt = 50$

Inflation premium

Inflation is the sustained increase in the aggregate price level that lowers the purchase power of our money over time.

What you can buy today with 1000$ is not the same that you can buy next year with 1000$. For example, with that amount I could cover ~7 months of health insurance 3 years ago, but this year I can only cover ~6.

So, when you’re giving away $10k for free, even getting them back in full will hurt your purchasing power. The amount of food you can get, bills you can pay, meters you can drive, house you can buy are all lower than last year.

The real question is how much?

Well, let’s assume that you’re living in a developed country. Most of my readers are from US, UK, Netherlands, and Germany so it’s safe to assume that they don’t suffer from hyperinflation. A sustained 2% increase is the most adequate number to use for this example, as it’s an amount that makes the economic machine work.

So, when giving your friend 10 000$ for free, even if you get them back, you just lost 2% of your money.

Why would you throw away 200$ on nothing?

Once again, maybe it’s a small amount to you… Maybe you’ll spend this exact amount on a good whose price won’t increase in value that much…

But wait!

Why worry about how to manage your budget in the future, when you’re offering help to your friend today? He should be a good friend himself and offer to cover your losses up front.

So, similar as with the risk-free rate, he should give you 200$ to account for inflation.

Current debt = 250$

Default premium

Default premium is an adjustment a borrower has to pay to the lender for the risk of him defaulting on his obligation.

In the Stocks & Bonds post we described how corporate bonds are rated by credit-rating agencies such as Moody, S&P, etc. Of course, their rating influences their rate of return. The riskier the loan the higher the yield, the safer the loan the lower yield – typical risk/reward scenario.

So, what happens if the day comes and your friend is incapable of paying you back? Even if you trust that he will, what if his daughter marries that week? What if he needs medical help? What if his mother dies and needs unexpected cash for a funeral? Will you hold him accountable and demand that he pays back no matter what?

But we went too dark too quickly… We’re ignoring the essential question itself – what if he decides not to pay back?

Okay, you know this guy – you’re certain that he won’t decide not to do it, but you’re not really certain that he will be able to do it.

I mean, assess his debt-repayment capabilities… He went out of money – and it can happen to anyone, so no judging. However, if we do proper analysis about his creditworthiness (AKA credit analysis), we can immediately conclude that he doesn’t have any savings and spent more than he earned. He didn’t plan for this scenario up front and was hit by the reality. His money management and mid-term planning skills aren’t convincing… Long story short, I’d say that there is a non-insignificant probability that you won’t see your money ever.

But for the sake of this post, I’m putting an extremely, extremely conservative 2% on this.

Actually, let’s go even lower! 1,5% default premium – and you’d be making him a service, he’s not getting anything similar anywhere.

Current debt = 400$

Liquidity premium

Okay, you gave your friend the money. Some time passes by, life happens, and you need cash next week. What do you do?

Well, let’s see the alternatives. If your money was in a savings account, you would’ve pushed a button transferring it to your checking account and have it available for spending. If your money was in a long-term bank deposit, you’d forego the interest, pay a small penalty for premature withdrawal, and again, have it available for spending. In other words: your wealth is pretty liquid.

But what about your loan?

Well… We already priced in the default premium for the risk of him not paying back. But what about liquidity – giving you the cash whenever you need it, even with a discount? Long story short: it’s pretty improbable. You’d have to chase him, go through a series of uncomfortable discussions, feel guilty, and ultimately ruin your relationship a bit. Not cool.

And we were only looking at a scenario where you need to money for spending, but what if there is an investment opportunity open for a limited time? There is a potential 100% ROI waiting for you, but you’ll have to put $10k less because your friend operates with your capital. This can create an enormous opportunity cost.

In summary, you don’t know what life will bring over the next year, so you should also demand a premium for not being able to convert the debt into cash at its fair value at any moment you want to. The rate is different for different asset classes and scenarios and should be adjusted based on the current macroeconomic context and expectations. For the sake of this post, I’d put it at a conservative 0,5%.

Current debt = 450$

Maturity risk premium

Well, we successfully estimated / assumed today’s risk-free rate and all the other premiums… But you’re not committing to a financial obligation with a duration of one day.

What happens if things change in 2 months and all of a sudden you have a risk-free rate of 2% available instead of the 0,5% you foresaw? What if the inflation rises from 2% to 3% this year?

They can also go lower, but that’s just proves the point again: you didn’t invest your money yesterday, but you gave them to a friend instead.

The longer they hold your money, the greater the chance that something will change. In other words, the longer they hold your money, the higher maturity risk premium you should demand.

So, debt with one year maturity? Half a percent is good enough for a friend (as mentioned, 1Y US T-bill is 1,57% at this moment).

Current debt = 500$

Current debt as a percentage of the principal

So how much is 500$ of the full principal amount of 10000$?

500 / 1000 = 0,05 = 5%

Oh, we ended up on the same amount we declared as “too high for a friend” at the beginning… Here’s the breakdown of our premiums:

0,5% risk-free rate
2% inflation premium
1,5% default premium
0,5% liquidity premium
0,5% maturity risk premium

And remember that neither of these premiums have anything to do with repaying the principal itself. This is literally money you’re throwing away if you don’t price these costs in.

Also, don’t forget that we used some heavy discounting on these premiums. The realistic cost of financing this debt is more than 10%, so there is no wonder why loan originators and credit card companies all end up on numbers in that range.

And have in mind that we only cherry-picked a handful of premiums, but I can think of way more items to cover – concentration risk, operational risk, country, legal & political risk, your costs of capital, the lack of blanket lien or any assets pledged as collateral, reputational risk etc., etc., etc.

But okay… You’re not a bank, this is not an investment, and you want to help out.

I get it!

Now, what you need to get is that you’re giving 10500$ and will get 10000$ back.

What if they’re really in need?

Indeed, up until this point I was assuming an irresponsible person. Thus, I have a justification method if you have the dilemma of whether to help or not.

Ask them for a bank statement.

If you see their money were spent on shoes and tobacco, they have no business asking for money.

I know all this may sound selfish to many, but don’t forget that you could be them. You could overindulge today and be left with nothing in a month. You could have given up trying to manage your personal finance because it’s too complex. You could have given up your career because it’s too stressful. You could’ve had 5 children although you could barely sustain the life of 1. It’s on them.

Unless they were really deprived of any opportunity in life, their financial situation is completely their responsibility and you should stay away from it.

A few months ago I watched a video called “Congresswoman grills billionaire CEO over pay disparity at JP Morgan” (link – but doesn’t matter). In the video, she’s blaming the CEO about a JP Morgan employee who earns low wage, lives in California, and has a daughter.

“How should she manage the shortfall while working full-time at your bank?”

Well, my apologies on behalf of reality, but: that girl had no business having children before being able to raise them.

And I have every right to say this and don’t feel any guilt about it because I’m consciously depriving myself of potentially the most beautiful experience because I’m still not sure if I’ll be able to sustain it.

In other words: I’m a responsible adult.

But let’s help

Okay, let’s not act like banks and robots.

Although I’m more strict about lending money today, I also helped friends and acquaintances in the past. There are only a handful of examples where the relationship didn’t deteriorate at all.

If you absolutely want to help, here’s my blessing: don’t just do it, but try to really help them out.

Teach them how to catch fish for life instead of feeding them once. Teach them how to build an emergency fund, how to save, and how to invest.

If they don’t care, still, be there for them. But there is a hidden risk we didn’t quantify into an arbitrary rate: the risk of saying goodbye to the exact amount you decided to lend, and most importantly, to your friendship as well.

So that’s why you should most probably say no.

In the name of your friendship, just say no.

Afterword

If you want to lend money the right way, either buy bonds or finance some loans through P2P lending and get 10%+ interest in a completely set-and-forget manner.

Here are some platforms I had experience with and you can open an account on: