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:

Many borrowers thought the idea for the loan originated with the lender, not themselves, although the lenders thought otherwise.

Borrowers reported far fewer delinquent loans than lenders, confirming Franklin's hunch.

Borrowers were fairly confident they would eventually repay the loan, but lenders thought even one missed payment probably meant the loan would never be paid off.

Delinquent borrowers "are much more likely to report feeling guilty, and also strangely, relieved and happy. Lenders associated with delinquent loans, in contrast, are much more likely to report feeling angry."

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.

"One of the very surprising things we observed was that unpaid loans created really bad feelings in lenders," Loewenstein said. "They were very upset about it and they believed that the borrowers were feeling very guilty, but the borrowers, maybe in part because they think they will eventually pay the loan off, were amazingly unconcerned about the unpaid loans. The borrowers tend to have a real blind spot for the misery and anger and disappointment of the lenders."

Most of these problems probably could have been avoided had the borrower and the lender sat down together and drawn up a written contract.

"There is almost universal failure to write out a contract stating the expectations" between the two friends, Loewenstein said.

"This is probably the central problem with personal loans because with no record, the self-serving bias can sort of prosper because there is no record of the terms of the loan or how much has been repaid.

"That's very much at the heart of the problems associated with personal loans," he added.

So what's lost in all of this? Not a lot of money. But quite likely, a valuable friendship.