We all get into a situation where we need to spend for an urgent matter like a sudden medical emergency or home repair. While we may have savings, it is sometimes not enough, and we resort to borrowing money from either family or friends just to get by.
Our family and friends are considered as informal fund sources and usually they are our first option to borrow money from because it’s more convenient. Because you somehow rely on trust, terms are more flexible and you don’t need to worry about any paperwork.
According to the National Baseline Survey on Financial Inclusion by the Bangko Sentral ng Pilipinas, majority of Filipinos have experienced borrowing money and most Filipinos (61.9%) borrow money from family and friends. It’s common practice, but if you are looking to borrow money from them, ask yourself first the following questions:
How much money are you going to borrow?
Informal loans may work to your advantage if you only need to borrow only a small amount. Most of the time, the “bank of family” or the “bank of friends” do not have enough funds to cover the entire amount you need. So if you need to borrow a big amount, you will end up borrowing from multiple sources, which may cause problems later on because of the multiple interest rates and paying periods.
Who are you dealing with?
Family and friends usually agree to lend money with zero or lower interest rates. This may work to your advantage, but you should be careful of lenders who may abuse your situation. Because they know that you are in dire need of funds, they may take the opportunity to earn more from you through interest rates that are even higher than what a formal lending institution would charge you.
Interest rates and other charges from formal lending institutions are regulated. The additional charges are not arbitrary and are computed based on the loan amount and the payment schedule to settle your debt.
The main concern with informal loans is that unlike formal lending institutions, there is no way for the lender to assess the capacity of the borrower to pay. This means that you may be buried in debt if you borrow a large sum of money without any secure source of income. The requirements demanded by formal lending institutions may entail more from your end, but these will protect you by ensuring that you have the capacity to fulfill your financial obligations.
Are both parties willing to enter into a formal agreement?
You may have heard of stories about family or friends who end up in court because of unsettled debt.
Most informal loans rely only on verbal agreements. So without a formal agreement, the lender can manipulate the terms to his/her own advantage since there is no legal contract involved. The terms may even change without prior notice. On the other hand, the borrower may default on his or her loan which may leave the lender at a disadvantage.
So it makes good sense to have agreements formalized to hold both the lender and the borrower accountable to each other.
The major disadvantage of informal loans
In a study called “(Dis)Advantages of Informal Loans”1 from the Simon Fraser University Department of Economics, researchers discovered that borrowers still prefer to go to formal lending institutions if only they were more accessible and have more affordable transaction rates.
This may be counterintuitive given the convenience of informal loans, but according to the same study, informal loans may seem convenient and practical, but it involves “social collateral” instead of “physical collateral”. This only means that while the monetary risk isn’t as high as in formal lending institutions, borrowing from family or friends may put your relationships and social connections on the line. There is trust involved in the transaction and when you break the trust, there is a slim chance you can earn it back.
By itself, borrowing money from family and friends is not necessarily a bad thing. It’s quicker and more efficient, especially in times of emergencies. But it is important to keep in mind that no matter how flexible it can be, an informal loan has its advantages and disadvantages. Given the risks involved, be sure to carefully assess when an informal loan is your best option.
1 Simon Fraser University. (Dis)Advantages of Informal Loans