Borrowing from a friend or from a loan company: which way is better?

You may have encountered this situation before. You require funds for an impending expenditure, but you realize you may have a shortfall for a number of possible reasons. At this point, you have a few options available to you. You can approach a bank or a lender for a loan, you can ask a friend or family member for help, or you can sell off certain assets you own to raise some funds. Depending on the amount of funds you need and the timeline by which you need them, each option may be more or less attractive. However, assuming that you have the luxury of time and find yourself needing to borrow a sizable sum of money, which way do you go? Lender or family?

The Lender Route:

Lenders can be any external capital provider from a bank to specialist finance companies to online lenders whose main business model is to provide loans to people or small businesses. Given that this is what they are built to do, there are obvious advantages of using a lender for obtaining a loan. Typically, established lenders have a history of working with customers, understand how to structure a loan based on the customer’s profile, and have professional teams that draw up contracts and other documentation. Some of the primary advantages of using a lender are as follows:

• Professionalism: As aforementioned, lenders are well-equipped to handle a wide range of personal finance needs, and employ teams whose sole job is to facilitate providing loans to customers who require them and have the means to pay them back.

• Speed: Lenders generally have larger reserves of capital than most individuals that can be deployed quickly to provide loans. If you are looking for a sizable amount of funds within a few days, lenders might be able to mobilize that more quickly for you.

• Credit History: When you repay a loan on time, lenders report that to credit agencies who then record that and assign you a credit score. The higher your credit score, the better your chances of obtaining financing at lower rates.

At the same time, there are several points of consideration to keep in mind when using an external capital provider such as lenders. Some of these are listed below:

• Interest rates: Depending on your credit score, lenders may charge varying rates of interest. Higher credit scores can lock in lower rates and vice versa. If you have an average to poor credit score, you might find that you are paying a higher comparative rate of interest.

• Loan terms: Loan terms provided by lenders are rigid, and generally cannot be altered unless you choose to refinance or roll over the loan. That means that you have to make payments as scheduled each month – there is little to no flexibility.

• Security: If you have taken out a secured loan such as a home equity line of credit, then a default on the loan may cause you to lose that collateral. In addition, both secured and unsecured loans also have expensive penalties and other fees for missed or late payments.

The Friends or Family Route:

On the other hand, you can also tap into your network of friends and family to request some cash. While this may or may not be an awkward conversation depending on your dynamics with the individual, it is important to remember that most people are not loan professionals, and so cannot give you the same financial advice as a professional loan officer. Nevertheless, here are some pros of using your network to access funds:

• Lower interest (possibly): Particularly if you have average to poor credit, friends or family may be willing to give you a lower rate of interest than a lender would be based on your personal connection with them. Again, this is just a possibility – they are not obligated to do so.

• Flexible terms: Based on the personal connection, friends and family may also be willing to forgive a repayment in a single month if you are particularly hard-pressed for funds.

• Security: Unless you have an explicit contract in place that states that in an event of default, the ownership of an asset will transfer to the friend or family you are borrowing from, they are not able to lay claim to your assets.

However, there are several downsides to working with friends or family for financial matters.

• Strained relationships: Perhaps the biggest risk is the prospect of tension in the relationship if repayments do not occur on time or as expected. Decades-old relationships have been and can be challenged for matters of money.

• No credit history: Individuals do not typically report to credit agencies, so even if you pay back your friend or family member on time, this does not impact your credit score whatsoever.

• Limited capital: In most cases, friends and family members are limited in the amount of capital that they can spare for lending to other people. Furthermore, if they have a cash crunch down the line, they may need the funds back immediately too. On the other hand, a lender will typically not call the loan back unless there is a valid reason to do so.

Best Practices

In general, if you do decide to borrow from a family member or friend, it is best practice to treat the loan as you would from an external lender. Don’t take advantage of your relationship with them, and don’t assume that they will be okay if you missed payments or didn’t make them on time. Ideally, a contract should be put in place that at a minimum stipulates the amount being lent out, the interest rate, and the frequency of repayment.

Summary

While borrowing from a friend or family member may have certain advantages from a flexibility standpoint, in most cases, it is not worth threatening the relationship and emotional bond you have with the person. Particularly if you have a reasonable credit score and a steady source of income, you can access relatively cheap financing and strengthen your credit history over time without damaging any of your relationships with your close network.

Get in touch with our reliable team of professionals at Magical Credit today to evaluate your options!