Do you have a passion you want to fulfill by borrowing money? Borrowing money from friends, family, a family business or a trust is a real and serious commitment and must be managed responsibly. Borrowing for the right reason can increase the chances of getting a loan. Below is everything you need to know about why, how and under what circumstances borrowing from family or friends might make sense for you.
Why would I borrow from my family or friends?
There are many good reasons to borrow from family and friends. The following are a few examples:
- Buying a home
- Getting an education
- Building your credit history
- Getting a car loan
- Medical procedures
- The bank won’t lend you money
- Lowering your monthly payments “debt to income”
- Supplement an existing bank loan
- Consolidating credit card, personal or education loans
- Home improvements
If I have a good reason to borrow, what do I need to know?
Be prepared to answer some basic personal and financial questions about your loan request. Be honest and straightforward with your answers.
- How will I use tthe money?.
- How you will pay back the loan?
- What are my personalincome and expenses?
- If I am borrowing for a business, what are my business income and expenses?
- Am I offering collateral for the loan?
- How will this loan help me achieve my personal or business goal?
Approach borrowing from a family member, friend, or family trusts the same way you would approach a bank. Start your loan by writing down the answers to the following questions:
- What is the purpose of this loan?
- How much money do I need to borrow?
- How many months do I want to make payments? How long do I need the loan??
- Where is the loan repayment money coming from to repay the loan?
- What if I am late making payments, what is a fair late fee?
- Can I offer any collateral?
- How often am I going to make a payment? Weekly? Monthly?
- What interest rate am I willing to pay?
- What monthly payment can I realistically afford to pay?
How much can I afford to borrow?
A common way to understand if someone can afford to make a monthly payment is to calculate the debt-to-income ratio, which is the total amount of current payments including the proposed new loan payment, then divide the total of all payments that by the borrower’s net monthly income.
The financial term for this calculation is the “debt-to-income” ratio. You basically add up all your required monthly payments and divide it by your monthly net income (after taxes).
All payments would include: credit cards, car loans, other loans, housing expenses, mortgage payments, property taxes, interest, insurance, and homeowners fees. These represent your monthly debt expenses. You want to compare this to monthly net income.
Net income is your net after taxes salary or wage. Here is the formula to calculate “Debt to Income:”
X = total monthly payments
Y = new monthly loan payments
Z = total monthly income
= Debt to income (“the affordability of the monthly payments”)
Dept-to-income ratio Example:
|Expenses||Current Payments||Proposed Payments|
|Credit Card Payments||$ 300||Paid off|
|Education Loan||$ 500||Paid off|
|Rent||$ 800||$ 800|
|New Consolidated Loan||n/a||$ 350|
|Total Expenses||$1,600||$ 1,150|
|Net Income after taxes||$3,500||$3,500|
|Debt to income (Payment Expenses / Net Income)Net Income after taxes||45.7%$3,500||32.9%$3,500|
|Debt to income (Payment Expenses / Net Income)||45.7%||32.9%|
How do I use my debt-to-income ratio?
Lenders all have different requirements, but a debt to income ratio of 35% is preferred. Once you calculate your debt-to income ratio, you can use it to justify your loan request and your ability to show how you can repay the your loan. based on your current income and expenses.
One of the benefits of a private loan is a family or friend lender might be more willing to advance money with a higher debt-to-income ratio than a bank. Knowing your debt-to-income ratio demonstrates that you understand how to borrow and will likely help your lender make their decision to make you a loan.
Can I reduce my debt-to-income ratio?
Yes! Borrowing to lower your monthly costs makes sense everyone! Sometime you’ll read advertisements that refer to debt consolidation loans. Those debt consolidation loans generally help reduce a borrower’s debt-to-income ratio. If your debt-to-income ratio is higher than 36%, here are some ways to reduce it:
- Extend the term of the loan so your payments are smaller
- Don’t take on any more debt
- Don’t use your credit cards
- Consider using layaway programs
- Avoid increasing your monthly fixed expenses
- Rather than making large purchases on credit, consider paying off debt by making extra principal payments and postponing any major purchase.
Whether you are borrowing to buy your first house, a business or to go to school; understanding how debt and income work together will help you make great borrowing decisions your entire life!
This article is part of a 2-part series. Read Part 1: For Lenders if you are considering lending money.