Informal borrowing often seems like an attractive funding option for investors looking to finance a new real estate project. After all, it’s a quick and easy solution when cash is tight, and there’s often no paperwork, no credit checks, and no interest. However, for all those benefits, there are plenty of cons to match, and borrowing from friends and family can often backfire. Read this article as we explore the risks and alternative financing options borrowers can take instead.
Why Borrowing from Friends and Family Can Backfire?
Strained Relationships. Borrowing finances from family may cause some strain on your personal relationships. With a professional lender, when the borrower can’t pay on time, they often have a fallback via collateral or impose late fees to make up for the inconvenience. On the other hand, informal borrowing relies heavily on trust. And the lender may not have the cushion to pay their bills when a close relative or friend disappoints. As a result, failed promises can lead to resentment and disappointment that leads to financial distress. It can permanently fracture relationships as well.
Lack of Clear Terms. Another way informal borrowing can backfire is that it often comes with unclear terms. A lot of agreements may happen through discussions, with no contractual obligation. Doing this can leave payment timelines and other terms open for interpretation since it’s not written. This form of financing has the highest risk of misunderstandings about when or how the borrower will repay. Without clear terms, both parties may make assumptions that cause conflict down the line.
Cons of Informal Borrowing
Lack of Legal Protection. Besides causing strain to your personal relationships, using informal borrowing as a funding source comes with significant drawbacks. For starters, there’s no legal protection. That means, when there’s a dispute about repayment, interest, or deadlines, it’s difficult for either party to collate enough evidence to seek a legal settlement. Without a proper written agreement, both parties may have to give the court the final say on whether an informal agreement was a loan or a gift. More often than not, such cases turn into a messy battle of he said, she said. This leaves borrowers vulnerable and lenders without a way to enforce repayment.
Higher Risk of Predatory Lending. Without a formal lending structure, borrowers are often at the mercy of lenders who aren’t bound to follow financial consumer protection laws. You could find yourself repaying a loan at exorbitantly high interest rates. You may also have to deal with ambiguous repayment terms that cost more in the long run. Adding the dynamic of close family and friends also means that the lender may resort to emotional intimidation. They may also use aggressive collection tactics that weaponize their proximity to your personal life. In other financing options, these methods are rarely an issue as they’re deemed unethical.
No Credit Building. Informal borrowing is often the go-to for investors with bad credit. But even when you repay a relative’s loan on time, it has no bearing on your credit score. In other words, if you’re looking to improve your financial standing and build a better credit history, borrowing from friends is not the way to go. Thus, traditional loans are your best bet if you want to leave a trail of good financial management, even if they come at the cost of paying interest and having less flexibility.
Alternative Financing Options for Borrowers
Private Lending. This option refers to a broad term that also includes informal borrowing from friends and family. It also extends to more structured and regulated bodies such as investment groups, peer-to-peer platforms, and hard money lenders. Besides having a faster turnaround due to fewer requirements, they’re also more flexible, giving you room to negotiate your repayment schedules, interest rates, and additional fees. Contact a reliable hard money lender in Maryland to protect yourself from excessive hidden fees that may surprise you during the process.
Home Equity Loans. This type of loan allows you to borrow against the equity you’ve built in your home. Equity is the difference between your home’s market value and the outstanding balance of your mortgage. For example, let’s say you bought a house worth $200,000 and have so far paid half of it off. It would mean your outstanding loan is $100,000. If the house’s current value is $250,000, that means your current equity is $150,000, and lenders are often willing to give you a percentage of that in a lump sum with a home equity loan. However, it also comes with the risk of using your property as collateral.
Business Lines of Credit. For small and medium-sized enterprises, a business line of credit allows you to borrow funds within a pre-approved limit as needed. Thus, this financing solution makes it easier for business owners to manage their cash flow and avoid fluctuations that could paralyze business operations. It’s also flexible enough to allow you to seize time-sensitive opportunities without the hassle of waiting for a traditional bank loan approval. For example, you can use a portfolio line of credit to borrow against the combined equity of multiple investment properties. The money can go into the acquisition of new properties, financing renovation projects, or as capital to cover daily operational expenses in your rentals.
Conclusion
Informal borrowing may seem convenient, but it comes with a lot of hidden costs. If it backfires, it can permanently mar your relationship with your family and friends. It’s a scenario that’s likely to occur since this type of funding often comes with ambiguous terms. As a result, there’s often very little, if any, legal protection involved. This leaves borrowers vulnerable to extortion and lenders risking default payments. It also doesn’t help your credit, which can be an issue if you’re trying to improve your score. That’s why alternative funding sources such as private lending, home equity loans, and business lines of credit are a better option than informal borrowing.
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