Bank of Mom & Dad

Not that long ago, a middle-school band teacher like Mark Witt would have been able to finance a mortgage in Phoenix, no problem. Then the real estate market crashed, taking with it the easy-money mentality that made getting a loan as simple as strolling into the office of the nearest mortgage broker. So Witt, scrambling for $7,000 to make a down payment on a three-bedroom house in a historic district, turned to a source closer to home: his dad.

Bob Witt, a retired CEO, was glad to help out. He even offered to pony up the whole $250,000 purchase price, at a bargain interest rate of 4.25 percent. But to make his terms perfectly clear, Bob went one step further: He insisted on putting the entire transaction in writing. “It’s not a gift,” he says. “I wanted him to treat it like a real loan.”

Even among the people who love you most, it turns out that a promise and a handshake just aren’t good enough today. In these tough times, friends and family are willing to help out — with strings attached. While they’re not looking for a pound of flesh, a growing number are insisting on promissory notes, payment plans and regular credit reporting. And they’re getting it. Virgin Money, a Massachusetts-based company that structures loans between friends and family, has seen its loan volume grow 75 percent in the past year. At populist legal publisher NoLo, sales of its most popular do-it-yourself loan kits are up 30 percent in the same period.

And this is only the beginning. As the economy gets worse, more people will need loans, but thanks to the credit crisis, banks aren’t exactly eager to help out. Mom and Dad, on the other hand, just might be: Baby boomers and their parents are sitting on assets worth an estimated $40 trillion. And next to the stock market, a friend in need doesn’t look like such a bad bet.

But contracts and payment plans still can’t force a borrower to pay — and an unpaid debt will wreck a relationship faster than you can say “IOU.” Shakespeare famously cautioned against borrowing and lending, and for good reason: “Loan oft loses both itself and friend.” Many advisers today echo that advice — if you must, never lend more than you can afford to lose with no hard feelings. Jim Grubman, a psychologist who specializes in families and money, says things can start to go bad the minute money changes hands. “Even the suspicion of a missed payment can strain a relationship,” he says.

People have been hitting up friends and family for loans for centuries, of course. And it’s been ruining relationships for just as long. Still, the practice persists: Nobody knows how big the market is for these loans, but some estimates suggest there’s as much as $90 billion in undocumented loans outstanding. It’s not much compared with the $14 trillion that banks have loaned out, but now traditional lenders are turning away borrowers by the truckload. Banks rejected a third of auto loan applications in the first nine months of 2008, and one in 10 small-business owners say they’re having more trouble finding financing. And as housing prices fall, banks are rapidly reevaluating — and even freezing — home-equity lines of credit.

Enter Aunt Suzie. Thanks to the Web, drawing up the paperwork has never been easier. And in fact, financial planners have long been advocates of making casual loans official. Putting the terms of the loan in writing — the amount, the interest rate, the payment schedule — clarifies the expectations of both sides. It also disabuses borrowers of the notion that the loan might miraculously transform into a gift. “If it’s a gift, why go through the charade?” says Sally Alspaugh, a financial adviser in Cincinnati. And even simple or casual documentation can turn an informal loan into a legal obligation, says Greg Beattie, a lawyer specializing in small-business law at MBV Law in San Francisco. Perhaps that’s why documented loans have a low default rate: Virgin Money says fewer than 5 percent of the loans it handles go bad, compared with 14 percent for private loans in general.

When a loan goes bad, though, it really hurts. Raised in an immigrant family that never talked about money, Laurie Moore figured no one would ask for a loan if he weren’t desperate. So when a friend asked for what she thought was a short-term emergency loan of $7,000, she said yes. In hindsight, Moore, 49, admits it wasn’t that smart. “But it was like, ‘You’re going to pay me back in two weeks? Fine.”‘

The two weeks passed, then two more, and Moore says that whenever she asked about the loan, her friend had an excuse. After six months Moore asked him to sign an informal promissory note. This past June — a year after the original loan — Moore turned to Virgin Money to formalize a payment plan, with a regular payment schedule, late fees and a 10 percent interest rate. It will take the friend another seven years to repay what was supposed to be a two-week tide-me-over. Now, Moore says, they rarely see each other, and their friendship is in tatters. “Financially, I’m still hoping to come out ahead,” she says. “Emotionally, I’m still way behind the curve.” She could try to go to court, but that would be exhausting and expensive — and certain death for the fragments of the personal relationship that remain.

It’s that kind of story that makes people reluctant to lend to friends or family — and it helps explain the success of Virgin Money. A finance Ph.D., Asheesh Advani founded the company in 2001, after a postgraduate stint studying family lending and microfinance for the World Bank. It’s a clever idea: For $200, the company will provide all the documentation to establish an informal loan; for an added fee, it will process automatic payments from the borrower’s checking account, too. What the company is really selling, though, is peace of mind. If a borrower is late with a payment, Virgin does the dirty work. It sends the borrower an official e-mail and reports it to the credit bureaus. In extreme circumstances, it will help a lender with collections or even foreclosure. In Virgin’s hands, a personal loan can feel a lot less, well, personal.

Apparently, Advani hit a nerve. Loan volume has more than doubled in the past two years; billionaire Richard Branson — who says a loan from his Aunt Joyce helped start Virgin Records — liked the business model enough to buy the company and rename it (the original name was CircleLending). Now there are products for student loans and reverse mortgages. And success breeds competition: a new company, GreenNote, encourages students to tap their friends and family for student loans; Lending Club exhorts would-be borrowers to milk their network via Facebook. Research firm Gartner predicts that peer-to-peer lending, broadly defined, will account for 10 percent of the world’s loan volume within the next three years.

Critics say that implied in all this infrastructure — and the marketing materials — is the suggestion that a documented loan won’t go bad. And while experts say that formalizing a loan improves the chances it will be paid back, it doesn’t guarantee it. That’s true of commercial loans, too, with an important difference: A bank spreads the risk of default over a huge loan portfolio so that the good loans more than cover the bad ones. (Historically, anyway.) Making one loan is riskier than making 100 loans, which is why financial planners often suggest just making a gift of the money.

Bob Witt didn’t do that with the $250,000 loan to his son — and so far, so good. Mark Witt, 47, has made four on-time payments of $1,229. But with two sons to support on a band teacher’s salary, Mark admits that money is tight. What happens if he can’t make a payment? He’s not too worried. He figures if he does fall behind, his father would be more forgiving than, say, a bank: “He wants to see his grandchildren are taken care of.”