Why It's So Dumb to Lend Money to a Friend

July 26, 2012 — -- Psychologists have finally figured out why Shakespeare was so right with that famous line from "Hamlet":

"Neither a borrower, nor a lender be; For loan oft loses both itself and friend."

When you borrow money from a friend or sibling or a co-worker, you enter a trust agreement that is a likely to be violated -- because we humans tend to rewrite our memories in a self-serving way. Psychologists George Loewenstein of Carnegie Mellon University and Linda Dezso of the University of Vienna put a name to the mental malfeasance that allows us to conveniently forget that we owe someone money. They call it the "blind spot."

Benjamin Franklin put it this way: "Creditors have better memories than debtors."

The researchers had 971 persons describe their experiences in a survey as either lenders or borrowers. Their study, "Lenders' Blind Trust and Borrowers' Blind Spots: A Descriptive Investigation of Personal Loans," was published in the Journal of Economic Psychology.

The study concludes with this old proverb, "Before borrowing money from a friend, decide which you need most."

Perhaps surprisingly, there has not been a lot of research on this subject, partly because the very nature of personal loans -- given in trust and usually without any kind of written contract -- makes them difficult to study. The researchers narrowed their study to loans between individuals, not loans from institutions or even parents, because it's safe to assume most parents know they will never see their money again.

But when it's a trust agreement between peers, it gets really tricky.

"Everyone suspects, and many people have their own personal experiences, that personal loans are a risky endeavor," Loewenstein said in a telephone interview. "People tend to process information about interpersonal interactions in a kind of self-serving fashion. We forget things that are inconvenient for us, and that's true of loans."

The survey documents a dramatic difference in the experiences of borrowers and lenders. Here are a few:

Of course, it didn't always turn out badly. Many of the participants reported positive results, leading Dezso, the lead author of the study, to conclude that while "lending can be hazardous to a relationship… personal loans can be lifesavers in many situations in which commercial loans aren't feasible."

The basic problem documented by the survey is that as the lenders and borrowers looked back on the initial agreement, they saw it very differently. In many cases the borrowers thought the lenders didn't expect to be repaid because it was an agreement among peers, a little help from a friend.

"Memory is highly reconstructive," the study says.

Loewenstein added, "People tend to remember the loans they give, and forget the loans that they get."

That can lead to a very different memory of the terms of any contract, with possible severe consequences to a personal relationship.