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Study confirms pitfalls of loans to friends, family

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By Michelle Singletary
Published:
You've probably heard many of the cautions about lending money to people you know.
As Benjamin Franklin put it, "Creditors have better memories than debtors."
In William Shakespeare's "Hamlet," Polonius advises his son Laertes, "Neither a borrower nor a lender be, for loan oft loses both itself and friend."
Anecdotes abound about relationships that are ruined because of unpaid personal loans. But if you still feel obligated to make a personal loan or guilty if you don't, new research should convince you that there is evidence of the negative effects on the personal relationship between lender and borrower.
George Loewenstein, a professor of economics and psychology at Carnegie Mellon University, and Linda Dezs÷ from the University of Vienna set out to measure the impact of personal loans on people's feelings. The researchers said their investigation is the first to academically study the consequences of personal loans between friends, co-workers, siblings and cousins.
Their study -- "Lenders' blind trust and borrowers' blind spots: A descriptive investigation of personal loans" -- appears in the Journal of Economic Psychology and was just published online.
The researchers examined two psychological issues. They wanted to know whether the two people in the financial transaction -- the lender and borrower -- are subject to self-serving bias when it comes to recalling different aspects of the loan. And they looked at when and how loans affect the relationship and subsequent interactions between borrower and lender.
They surveyed 971 individuals about their experiences with personal loans. Participants completed a survey on personal loans they had made and received within the past five years. They answered questions about the characteristics of the loans: size, purpose, amount repaid, presence of interest and existence of a formal contract.
Not surprisingly, at least to anyone who has personally lent money, borrowers can remember the transaction quite differently than do lenders. They are more likely to forget having taken the loan and are more likely to view it as having been paid off. Or if the loan hasn't been paid off, they think they've made more payments than they've in fact made. They also might reframe unpaid loans as having really been gifts.
To some extent, Loewenstein said in an interview, the research explains why lenders often feel borrowers seem cavalier about their obligations. Borrowers are optimistic about their ability to pay, with 87 percent thinking they will eventually make good. But only 35 percent of lenders think they will ever see their money again.
The damage to relationships often starts when personal loans become delinquent, the study found. Lenders feel that their trust has been violated. Borrowers then become resentful of being under the yoke of the loan, Loewenstein said.
"Friction between the parties is then exacerbated by the tendency of both to project their own feelings on their counterpart," Loewenstein and Dezs÷ conclude.
So there you have it, empirical data to back up what Franklin, Shakespeare and your mama have been saying for years. But Loewenstein and Dezs÷ don't want their study to be used to eliminate person-to-person lending. Rather, they hope their findings are used to help people understand and avoid the pitfalls.
"At the moment of initiating a loan, very often both parties have very unrealistic expectations," Loewenstein said. "A lender thinks the borrower is trustworthy. And the borrower is convinced he or she will repay the loan. People get swept up in the emotions of the moment."
So the researchers advise the following:
•Don't succumb to pressure to make an immediate loan. Think about the potential negative consequences.
Get a contract. Yes, this is personal but it can also get ugly if you don't detail the terms of the loan in writing.
Document payments. Lenders should give a receipt and borrowers should ask for one. Even though you both think you have a mutual understanding of the loan agreement, memories fade. And that's when feelings get hurt.
Most importantly, don't lend money you have to have back. Just give the money to the person in need.
"You should immediately write off the loan in your mind," Loewenstein said. "If you get repaid, that is wonderful. But go into a loan with the assumption that you are not going to be repaid."
And those seeking personal loans from family or friends should keep this proverb in mind: "Before borrowing money from a friend, decide which you need most."
Michelle Singletary: singletarym@washpost.com.
Washington Post Writers Group
Story tags » Personal Finance

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