Once upon a time, deals were done on the strength of a handshake. These days, however, it’s in everyone’s best interests to ensure any financial transaction is properly documented. In this article we discuss how to best go about lending money safely to family, friends and business associates.
If you are a high-income earner with surplus cash, it’s not uncommon for family members, friends and business associates to ask you to lend them money or invest in a project they may be working on.
If the proposition is more about you ‘doing them a favour’ and has the hallmarks of a business arrangement, it may be wise to either just give them the money or politely turn down the request rather than get entangled in a situation that could end in tears, recriminations or irretrievable family disputes.
Such arrangements, especially lending, need to be formalised with an agreement and security in place in case the borrower defaults on repaying the loan or due to other financial difficulties that could impact you.
Clearly articulating your lending terms is important for avoiding any misunderstanding between parties. Even so, you should recognise the possibility that if things go badly, despite your best efforts and written agreement, there could be irreparable damage to personal relationships.
If you do feel you are in a position to privately finance someone or their project, you need to behave more like a bank than a friend or relative, especially if the loan is over a long term.
Like a bank you will have to have a formal loan agreement and security documentation.
The key is to have clear, legal, written documentation of BOTH the loan agreement AND the security taken against the loan. This is because, security is only a safeguard for the loan amount if there is a documented liability to actually pay the debt. Importantly, the loan agreement itself must be enforceable and your security interest will generally only be valid if it is provided at the SAME time a loan agreement is made.
You will need to properly document the amount of the advance, interest payable on the amount (if any) and details about repayment requirements such as frequency of instalments and the completion timeframe.
In the case of loans to family members, there are often no specific repayment expectations, however nominating a repayment time frame in the loan agreement gives certainty and increases the enforceability of the loan should yours or their circumstances change. If you reach the stated time for repayment, you can always provide an extension.
As to security, and there are three common options, which are not mutually exclusive:
Personal Property Securities Act 2009: A General Security Agreement under this Act provides security over all of the assets held by the borrower. This type of security has greater value in circumstances where a business has tangible assets. These assets would usually include plant, equipment or stock that can be sold to recoup the unpaid loan and/or any interest payable.
Personal guarantee: In a business lending situation, one or more company directors or shareholders would be asked to offer a personal guarantee that the money be repaid. Care must be taken with personal guarantees to ensure that the guarantor knows and understands to what they are agreeing and has or has the opportunity to seek independent legal advice as to the guarantee.
If the company, individual or one or more company directors or shareholders you are lending to own land you may also wish to require a mortgage over the property owned.
The value of the security will be limited by what the creditor actually owns (you can’t get blood out of a stone) or what security any other creditors may already have in place.
For example, a bank may have a mortgage over the same property you also intend to as security.
While it’s important to beware of any other creditors who may be ahead of you, should things go wrong, being listed as a secured creditor as this will place you in a much stronger position than an unsecured creditor.
Before entering into any private lending arrangements assess your own capacity to lend money by reviewing your surplus cash situation. Consider (perhaps in consultation with your financial adviser) any future circumstances that might mean you will need access to that money; or if indeed you don’t need, or wish for, it repaid at all.
You should formalise arrangements. Ask your lawyer to document clear loan terms including the principal amount, repayment arrangements including interest rate, and details should the borrower default.
You should also seek accounting and taxation advice prior to entering into any private lending arrangements. Private lending can be very rewarding way of helping others, so it’s important to take a structured approach which is all about good practice, clear communication and in the spirit of achieving goals.
Take it from me, those who are given the opportunity to benefit from your ability to provide private lending won’t think you are some kind of modern-day Scrooge with rules and obligations, they will be appreciative of your generosity, and your organised and fair approach.
The information in this blog is intended only to provide a general overview and has not been prepared with a view to any particular situation or set of circumstances. It is not intended to be comprehensive nor does it constitute legal advice. While we attempt to ensure the information is current and accurate we do not guarantee its currency and accuracy. You should seek legal or other professional advice before acting or relying on any of the information in this blog as it may not be appropriate for your individual circumstances.