Friendship and Money Not Always a Great Mix

While Shakespeare's "The Merchant of Venice" recounts the downfalls of lending money to a friend, a loan to a friend does not always have to result in the loss of both the friend and the money. Nowadays, a layoff, health crisis, divorce, death of a spouse or new business venture might result in a friend asking for money, so the question becomes, how do you respond?

What should you consider when a friend asks for a loan?

Obviously, lending money to a friend can complicate a relationship, so there are a few things to consider before saying yes. First and foremost, figure out if you can comfortably afford to lend the money. You may also want to think of alternatives to lending the money outright. For example, you could offer to co-sign a loan if your friend has trouble qualifying for one on his or her own. By doing this, the transaction becomes more businesslike, and the bank is the middle man. However, remember that if your friend is not able to repay the bank, you are ultimately responsible for the loan.

Another issue you need to clarify is whether this is truly a loan or more of an investment. So, if your friend is launching a new business and asks you for $10,000 to help with startup costs, are you investing in the business to experience both the ups and downs with the knowledge that you might lose your investment? Or is this simply only a loan and you expect to get all of your money back?

You should also consider what would happen if the loan were to go unpaid. Would it put you in a financial bind? Would you be able to think of the loan as more of a donation to a worthy cause? Keep in mind, you can give up to $12,000 in 2006 free of gift tax.

How can you avoid problems when lending money to a friend?

Communication and documentation are essential. Although a smaller loan of a few hundred dollars may require only a handshake, loans of larger amounts should be documented in writing.

A larger amount of money is any amount that you deem substantial given your situation, whether it is $1,000 or $15,000. When documenting a loan, you should capture everything involved in the agreement: the names of the lender and the borrower; the date of the loan; the amount of the loan; the interest rate, if applicable; the period over which the loan will be repaid; the amount of each payment and the frequency of payments. And both the lender and the borrower should sign this document to reflect your agreement. Although this written agreement helps to lay out the terms of the loan, it does not necessarily need to involve lawyers. However, if the loan is for a substantial amount, you may want to consider both legal and tax advice.

Once you agree to the loan, do not hang it over your friend's head and avoid meddling in your friend's financial affairs. If the friend is holding up his or her end of the bargain and has not asked for your ongoing advice, do not offer it, as it can put a strain on the relationship. Additionally, discretion is key. Odds are that it was very difficult for your friend to come to you for money, so the last thing the friend wants is to publicize the fact that you are lending the money.

Do you have to charge interest on a loan to a friend? Are there any tax ramifications?

It depends on the amount of the loan. If the loan is under $10,000, you are not required to charge interest. However, if the loan is for more than $10,000, you need to charge an interest rate that is at least equal to the applicable federal rate, or AFR, determined by the IRS. The AFR varies according to several factors, including the length of the loan -- short-term, mid-term or long-term -- as well as the repayment schedule -- annually, semi-annually, quarterly or monthly. For example, the AFR for a short-term loan repaid in monthly installments is 4.30 percent for February 2006.

If you decide to charge your friend an interest rate that is lower than the AFR, the difference between this interest rate and the AFR is considered a gift. So, if the AFR for a loan between you and your friend is 4.30 percent and you decide to charge only 2.30 percent, the 2 percent difference is considered a gift to your friend.

In order to avoid a gift tax, the amount of the gifted interest cannot exceed $12,000 in 2006. Keep in mind that as a lender you will need to report the 2 percent difference as income on your federal income tax return. Also, in addition to the federal rules on lending, you should investigate your home state's rules to make sure the terms of your loan comply.

How can you tell your friend no?

If you are financially unable or just too uncomfortable to lend money to a friend, it is important to be honest. If you lend money to someone who does not have the ability to pay you back, it would be far worse to hound your friend for the money than it would be to say no from the start. Although you may say no to the loan, you could offer to help your friend explore other options for getting the money. In addition, you might want to help your friend figure out his or her current expenses to determine ways to cut back to find the money within his or her own income.

How do you handle jealousy issues about money between friends?

Some of your oldest friends may date back to college and earlier -- a time when salaries were nonexistent or minimal. As you move into the work force though, one friend's salary may soon exceed another's by a small or significant amount, inevitably leading to envy. Whether you are envied or green with envy, it is important to make peace with your own situation.

If you are falling behind your friends in your finances, you may end up questioning your life decisions or resenting them for having the means to do more in life. However, if you let these feelings get the better of you, they will eat away at your friendships. You need to avoid comparisons and instead focus on what you have in common. Similarly, if you find yourself as the object of envy, appreciate your good fortune. But at the same time, do not throw it in your friend's face. Emphasize that you do not want money to come between you, and be cognizant of your friend's financial constraints when planning get-togethers.

Mellody Hobson, president of Ariel Capital Management ( in Chicago, is ABC News' personal finance expert. Matthew Yale and Aimee Z. Daley contributed to this report.