04 May Family Loans: the Friendly (or Not So Friendly) Loan
“Before borrowing or lending money to or from a friend, decide which you need most – the money or the friend”
Disclaimer/use of this information
This information is general in nature and does not constitute legal advice. You must not rely on it. Legal advice based on your specific circumstances should be sought by you.
Understandably, many people wish to assist family members or friends with loans from time to time. (“friendship loan”)
A friendship loan carries with it significant risk.
Our apologies for what may appear to be a negative tone in this information piece. The issues and concerns raised are often seen by lawyers in loan arrangements between family and friends. Too many of these arrangements turn bad. Too many relationships are significantly impacted on or end as a result of someone trying to help a close friend or family member with a loan. They are the sort of arrangements that must be very carefully considered by all involved and independent legal, taxation, accounting, financial planning and Centrelink advice obtained well before agreeing to proceed.
Some considerations may include: –
- Often, the need for the loan is due to the fact that a bank or independent lender will not make the loan. The friend in need has been assessed as too risky or unsatisfactory for lending purposes by the bank etc. This may also include having insufficient income, poor credit history, inadequate security etc. Anyone considering lending money to a friend must carefully reflect on why a bank etc. will not make the loan.
- There are many examples of friendship loans that have gone badly wrong. Often it results in a lender not being paid part or all of the loan, fractured relationships within a family etc.
- As lawyers, we have seen many examples of where a borrower/debtor family member or friend (“the Borrower”) has all the good intentions of repaying the loan but simply cannot do so.
- You (“the Lender”) should carefully consider what any loan monies are to be used for. Is it for the purchase of an asset of value such as real estate or is it for business purposes? Is the loan for the purchase of a car, jewellery or other personal effects? Can the Borrower truly afford what they are seeking to purchase? Should the Borrower simply not proceed with that purchase/transaction or obtain something less expensive etc?
- Will the purpose of the loan result in further loss or waste to the Borrower? Should the Borrower proceed with the proposed transaction? Can they really afford it?
- What is the Borrower’s credit, employment, savings etc history like? This can all be searched for via independent records if necessary. Searches should be done.
- What are you putting at risk by lending the money? Can you afford to lose all or part of the loan and not be repaid? Is your home, financial security, retirement or future being put at risk by what you are proposing?
- What percentage of your overall assets and financial resources are you putting at risk? If, for example, you have assets totalling $500,000.00 and the loan is $10,000.00 then the loan may represent a small percentage of your assets. If the proposed loan is say $100,000.00 then it represents 20% of your assets overall. This risk percentage should be carefully considered.
- It must be emphasised there have been many many examples where a Borrower wants to repay but simply cannot due to a number of unforeseen circumstances.
- The future will always be uncertain for both the Lender and the Borrower. What if the Lender’s needs increase? What if the Lender suffers financial hardship through changing financial circumstances, loss of employment, ill health etc?
- What if the Borrower suffers at some point in the future financial difficulties, loss of employment, business failure, bankruptcy, a messy divorce, health issues, mental health issues, develops a gambling habit etc? What if something like this occurs to a close family member of the Borrower (spouse, child etc.)? Again, the Borrower may genuinely want to repay but simply cannot.
- You should not enter any sort of friendship loan arrangements without obtaining careful advice from you accountant and financial planner. There may be tax consequences with any loan eg. tax on interest etc. There may also be Centrelink and pension implications of granting a loan.
- If you decide to proceed with the loan, the arrangements should be carefully documented. Any documents should be professionally prepared by a lawyer experienced in the area. With respect, any loan documents should not be prepared by non-lawyer such as an accountant, JP, bank manager etc. A non-lawyer preparing such a document is unlikely to have the necessary experience, expertise or professional indemnity insurance.
- If the loan is to proceed, what are the loan terms? What amount, repayment terms, interest rate, security etc? All of this must be carefully considered and carefully documented.
- The document should be prepared for the Lender. One lawyer cannot act for both parties. Each party must be given ample opportunity to read, consider and obtain independent legal advice in relation to the document. Each party must carefully check the documents and obtain any necessary advice. This should include taxation and financial planning advice.
- Who will be the Borrower? Should it be more than one person? Possibly husband and wife? Often, the more persons responsible to the Lender for repayment, the greater the likelihood of being repaid.
- Who is the Lender? You, you and another, your company, your trust etc? Please consider and seek accounting advice.
- If the loan is to a family member’s/friend’s company (which is normally always very dangerous!) then you should consider director’s personal guarantee. This guarantee may also include the spouse of the director and others.
- In relation to guarantees, their value is only equal to the assets and financial ability of the guarantor to repay if called upon. If the guarantor does not have the assets or financial ability to repay, the guarantee will not be worth the paper it is written on.
- Individuals, businesses or companies may look “successful”. There may even be significant real estate, motor vehicles and life styles factors which indicate “success”. There may however also be significant debts which in reality mean the “success” is illusory.
- Potentially complex and strict law relates to loans, security documents, mortgages, guarantees etc. These sorts of documents must only be prepared by experienced lawyers. Please see above in relation to that.
- Normally, one of the safest forms of security for a loan will be residential real estate within the Adelaide metropolitan area. The value of such real estate should be independently assessed by a licensed valuer. The value should not be “guessed”. Is there sufficient equity in the real estate? How much is a first mortgagee owed? Are there any other charges against the real estate? Who has the relevant Certificate of Title? Careful searches must be conducted in relation to all of this. Independent evidence (eg. confirmation from a bank re amount owed to it etc.) should be obtained.
- A mortgage should be registered with the Land Titles Office. At the very least, a caveat (notice to the world) should be registered with the Land Titles Office in relation to the mortgage. However, a caveat does not equal absolute protection. A mortgage can be registered even if there are other mortgages registered by a bank etc. Any earlier mortgages will take precedence over later mortgages.
- Where personal property is used as security (eg. a motor vehicle, company assets etc.), similar care should be taken in relation to assessing the value etc. of such security. Please see above in relation to that. This applies to preparing relevant documentation. Any such security should be registered with the Personal Property Securities Register. Professional assistance in relation to this should be obtained also. Any earlier registered security arrangements (eg. with the bank) will take precedence over later registered security arrangements.
- Should the Borrower and any guarantor be required to have adequate life insurance, income protection and trauma insurance? This may protect the Lender in the event of death and major illness/injury to the Borrower. This may assist in repayment. Should the Lender be the beneficiary of any life insurance policy? Everyone involved should have an up to date will, enduring power of attorney and power of guardianship documents.
- What is to happen if there is death or loss of capacity of the Lender or Borrower? How will this impact on the arrangements?
- What is to happen to any loan in the event of the Lender’s death? Should it be dealt with in the Lender’s will? Is it forgiven? Does the loan form part of the estate to be divided between others? The Lender’s will should deal with this. Should a clause that deals with the possibility of the loan not having been repaid yet still being taken into account in the division of the Lender’s estate be included in the will? All of this must be carefully considered. Advice should be obtained from an experienced wills and estates lawyer in relation to this.
- Sometimes, it may be worth considering being a part owner of a low risk asset with the Borrower. For example, if you are assisting someone to purchase real estate, motor vehicle, shares etc, you may wish to consider being a part owner of such asset. Your portion of the ownership may reflect the amount of money that you are providing. A document setting out the rights and duties of each party should be professionally prepared and signed. There may be tax consequences. You must speak to your accountant before committing to these arrangements.
- You should carefully reflect on whether you would be willing to enforce your security/loan arrangements. It is easy to say yes to this. However, in our experience, it is difficult for a Lender with a personal relationship to the Borrower to enforce security against the Borrower. Are you willing to sell any real estate (including the Borrower’s family home) if the Borrower defaults? If this is required, it will typically be very expensive (legal fees) and emotionally difficult to enforce. Many people find it emotionally impossible to force a sale of the Borrower’s property (particularly a family home) where their loved one and/or friend (including the family of such loved one or friend) are living there.
- Legal documents do not automatically equal actual payment. If there is a breach and the breach is resisted by the Borrower then the legal document will have to be enforced. This will be expensive financially and otherwise. These documents will normally provide that the Borrower will pay for the costs of enforcement. However, are they able to in fact pay? Is there enough equity in any security?
- Recent experiences have shown the relatively fluid and fluctuating value of assets. This includes real estate, shares, businesses etc. Assets may be difficult to sell. There value may have dropped significantly. This will all impact on the likelihood of repayment.
- Please think very carefully what you are about to do. What will this truly cost you (financially and emotionally)? What will family relationships/friendships be like after the loan? Will others in your family groups/friendship circle resent the fact that you have provided the assistance? How will all this impact on significant relationships, your finances, your future etc?
- Do not use internet based loan, security or other documents without independent legal and taxation advice. Are these documents valid, effective, and applicable? Resist the temptation to use “fast and cheap” internet based documents.
- Many people will later regret the decision to assist. Many people have suffered the loss of the loan monies and the loss of significant relationships when all they thought they were doing was helping.
- Do not sign any guarantee without detailed independent legal advice.
- Do not agree to anything without independent legal advice. Verbal agreements can be binding.
- Who pays for legal advice and legal documents? Normally, the Borrower pays. Raise cost issues with your lawyer.
- Self-managed Superannuation Funds cannot normally lend to or assist related parties.
- Superannuation interests cannot normally be used as security.
- There are increased legal complexities with lending to a company, trust, superannuation fund etc.
- Any security interstate or overseas may be difficult to enforce. Independent legal advice from a lawyer where the security is located will be needed.
- A de facto relationship may be established by two years cohabitation, a child of the relationship or significant contribution. This includes same sex relationships. De factos may have property rights under the Family Law Act. Does this impact on the proposed friendship loans?
- Should the Borrower or the Lender consider a “pre-nuptial” agreement to protect assets in the event of separation? These are called Binding Financial Agreements and are strictly regulated by the Family Law Act. They can be entered into before, during or after a marriage or de facto relationship. They are available for same sex relationships also. This may be relevant to the Lender.
Prevention! Consideration! Documentation! Quality advice BEFORE committing to an arrangement may save much money, anguish and difficulties later.
Once again, our apologies for what may appear to be an overly negative tone in this information piece. However, it unfortunately reflects the reality of what often happens. We are more than happy to provide tailored assistance to you in relation to these transactions if you wish.