loaning money

Why does it feel so bad when those closest to you hit you up for a personal loan or investment? Your heart says, “Yes,” but your brain says, “No.”

You are not alone. Affluent people get loan requests all the time, says Paul J. Zak, a neuroscientist and economist at the Claremont Graduate University. “We get a lot of pleasure from helping other people,” but sometimes, he says, the costs outweigh the benefits. Almost all of us want to help people, but doing so without being taken advantage of requires an almost clinical level of decision-making. 

It’s science’s fault: The emotional part of your brain reacts much quicker than what Zak calls “the executive part” — the prefrontal cortex area that does the cost analysis in any decision. Our initial response is to help, that’s why it pays to sleep on requests until your mind has had time to fully process of helping.

Most people understand that the costs of failure are much higher in a personal or family relationship than in a business one. When a business deal goes bad, you can sue your associate and promise yourself to never work with that person again, chalking it up to a bad investment. When a personal loan goes poorly, you may fume, and it may well sour a friendship or forever color your view of an in-law. You stay silent to keep the peace, but then someone else asks for help.

“Wealthy people may feel guilty about how much money they have,” says Zak, who has studied virtuous behavior relating to business decisions for 15 years. As head of the Center for Neuroeconomic Studies in Claremont, his 30-person lab experiments on how the “good hormone” oxytocin is released when we make decisions that actually help people.

We trust because we want to trust, our oxytocin hormone is released and we feel good, at least momentarily, he says. But then the executive part of our brain kicks in and says, “Wait a minute, I still have to sit across the table from this guy at my kid’s birthday party.”

A few of his suggestions emphasize taking out the personal aspect of the request. “Move it out of the emotional realm.”

Go through the exercise of articulating the real risk that is being taken on. The true risk of a closely held loan with family or friends is not monetary, it is emotional. Does the borrower understand, or care, that this loan could destroy the family dynamic or the friendship? Does the borrower truly understand that they will be required to pay it back? He may think he does, but when times get hard will they be as logical then?

Make your friend or family member do what a business associate would have to do. Make him prove that he has a good model for spending the money and a plan to repay the loan. “If the idea is strong enough, you can build a business model,” Zak says. Then look at the loan as a business investment and consider whether or not you will profit.

Use a third-party advisor to facilitate the loan. “Outsource the evaluation,” Zak says. “It may cost a percentage but it may be money well spent.” Decide with your advisor how much money you are willing to risk from your estate, and let your financial advisor or business manager do the paperwork and offer up options. Alternatively, offer to help the borrower find a good third-party lender to provide the funding. There is plenty of liquidity in America right now looking for a place to invest.

Consider it philanthropic entrepreneurship. Philanthropic entrepreneurs often lend money knowing that some of it will never come back. Zak gives the example of an affluent friend who lends money to women in Africa to start their own businesses. “He doesn’t expect a lot from his investments,” Zak says. But he wants people to be able to stand on their own two feet.

Consider giving a gift, rather than a loan. As you get older, you may be ready to divest some wealth. Alternatively, there are ways to make very low-interest rate loans with a debt-forgiveness component, so if your borrower can’t afford to pay it back, whatever does not get paid back operates as a gift. This type of structure requires good tax advice, so seek out a qualified professional first.

City National Bank, as a matter of policy, does not give tax, accounting, regulatory or legal advice. The effectiveness of the strategies presented in this document will depend on the unique characteristics of your situation and on a number of complex factors. Rules in the areas of law, tax, and accounting are subject to change and open to varying interpretations. The strategies presented in this document were not intended to be used, and cannot be used for the purpose of avoiding any tax penalties that may be imposed. The strategies were not written to support the promotion or marketing to another person of any transaction or matter addressed. Before implementation, you should consult with your other advisors on the tax, accounting and legal implications of the proposed strategies based on your particular circumstances.