If you have decided to ignore the well known advice of “don’t lend money to family or friends”, there are some very good reasons why you should agree a repayment plan and decide up front what will happen if the borrower is late in repaying or if the borrower cannot repay at all because they go bankrupt or die.
Most importantly, if you are going to take the place of a bank then it is important to make sure you act like a bank as much as possible. This includes:
- asking appropriate questions about the borrower’s assets and liabilities and income and expenses so that you can make a proper assessment of your risk in entering into the proposed transaction;
- agreeing repayment terms (many family loan arrangements are simply payable on demand but this comes with risks), interest rates (normal and default) and what constitutes a default;
- deciding whether the loan will be secured or unsecured. If it is unsecured one would expect a much higher rate of interest as the risk will be so much greater;
- working out the best collateral or security the borrower (or their loved ones) can provide in case the borrower is unable to repay the loan; and
- agreeing who will pay the legal costs of having appropriate documentation drawn up (normally the borrower).
Arguably, if you lend money to family or friends it is more important to keep things on a commercial basis.
The reasons why loan arrangements between family and friends should be properly documented include:
- unless the agreement is committed to writing it is all too easy to overlook important considerations;
- lenders and borrowers often make different assumptions (especially about repayment deadlines);
- engaging a lawyer to prepare documentation adds a level of objectivity to the transaction and the lawyer can advise on appropriate security;
- a secured loan between family members can be a very powerful estate planning mechanism which ensures the loan must be repaid in preference to other creditors and, importantly, that the loan will be repaid before property is divided in a failed relationship;
- a well thought out loan agreement supported by appropriate security will hopefully make both parties feel more comfortable about the transaction and avoid “bad blood” as a result of misunderstandings; and
- the process of documenting the loan may cause some prospective borrowers to understand that just because the lender is a family member or a friend does not mean the arrangement is casual or less important than a bank loan. I have seen some borrowers (and lenders) reconsider the whole arrangement when confronted with the commercial reality of the proposed loan (that it must be repaid strictly in accordance with the agreement and that the borrower (or a related party) stands to lose the secured property in a default situation).
Deciding whether security is necessary or not will depend on the circumstances and in particular on the size of the loan. Generally speaking I recommend that a lender should always have security for the loan (and the more the better).
Security may include any one or more of the following:
- where the borrower is a company, a personal guarantee from the directors or shareholders;
- where the borrower is an individual, a personal guarantee from the borrower’s spouse or parents;
- a registered mortgage of real property;
- an unregistered mortgage of real property secured by caveat;
- a mortgage or bill of sale over personal property registered on the Personal Properties Security Register (“PPSR”); or
- a security deed (fixed and floating charge) over company assets registered on the PPSR.
If you decide to proceed with a loan to family or friends I strongly recommend that you seek legal advice before proceeding (a one hour consultation could avoid a lot of heart ache!). At the very least you should have a properly prepared loan agreement and hopefully you will see the benefit of insisting upon the borrower (or a related party) providing appropriate security.
For further information please contact Danny on 8362 6400 or email Danny Beger. Join our mailing list to receive updates and advice on current issues.