From time to time we’ll see a first time developer who has worked up a project to the stage of it being good enough to be considered by a funder, however they are short on equity.
Who better to approach than people who already know you and trust your ability? They have seen you cook a good steak on the BBQ, which you assembled without the instructions, so if you can build a flat pack BBQ without stuffing that up, how much harder can it be to build a 5 storey residential tower?
Often a first time developer facing this kind of scenario will approach family and friends to raise the equity required to get the deal over the line. But given the relationship that the developer has with these ‘investors’, these form of equity loans are never documented properly, if at all. Time and again we hear the response, no need “He’s a mate and a good bloke” or “What could possibly go wrong?”
Well here are some reasons not to lend money to, or borrow money from, friends and family:
1. THE LOAN HAS NO END DATE AND SOMETIMES NO INTEREST RATE. These are not really loans in the true sense, as they tend to have no fixed repayment date and often don’t include an interest rate on the loan. So the friend doesn’t know when their money will be returned and the borrower often doesn’t know when exactly the project will be finalized and when he can repay the loan.
This leaves both parties in limbo and doesn’t set any firm expectations. But as time passes and the inevitable delays roll out, the uncertainty can lead to stress in the relationship as the borrower worries that the lender expects repayment and the lender worries about when or if they will be repaid.
Alternatively, the borrower may not realise that there is a sense of urgency to repay the loan and without a deadline; it becomes their last priority. The developer won’t face any repercussions for not repaying such as late payment charges, a higher interest margin or a negative impact on their credit score. Without the threat of penalties, they have no motivation or urgency to repay.
2. IT’S ALWAYS DIFFICULT TO ASK FOR THE MONEY BACK It can be difficult to request repayment of a loan from a friend or family member. More than likely, the lender cares about the borrower and doesn’t want the borrower to feel awkward. The lender may continue to worry about loan repayment and thus shut down some or all communications with the borrower in order to avoid talking about the loan.
3. IT CAN MAKE SOCIAL EVENTS AWKWARD Family get-togethers or social events can suddenly become very uncomfortable situations. The borrower may feel a need to avoid the lender for fear of discussing the situation, especially if they can’t add any certainty to a time to resolve the matter. Other family members who know about the loan can also become drawn into the situation with disastrous results.
4. THE BORROWER MAY ASK FOR MORE Once you have lent money to a friend or family member, this person may return when he or she needs more money. In addition, other friends and family members may also ask you for a loan. It’s always easier when they know you’ve loaned money before.
6. YOU MIGHT NEED THE MONEY YOURSELF You definitely want your money returned, but your circumstances can also change and you may need your money now! What if you lose your job and you spend your entire emergency funds while searching for a new job? What if repayment of the loan marks the difference between you keeping your house or losing it to the bank? Not receiving repayment of the loan in a timely manner might spell disaster for you and your family.
7. YOU COULD LOSE YOUR MONEY AND YOUR RELATIONSHIP
If you lend money to a friend or family member you need to be aware that you may not get your money back and your relationship may never go back to normal. This will cause tension between you and the borrower, and may also cause guilt, remorse, and anger amongst others who are related to you both.
In summary, if you are considering lending money to a family member and want it to be treated as a loan rather than a monetary gift, there are a few things that should be done:
- Seek legal advice to ensure that your agreement is properly prepared and correctly reflects the intentions of the parties;
- Ensure that all parties to the loan are named in the loan agreement;
- Ensure that the loan agreement is correctly signed and is dated by all of the parties;
- Be specific and include the amount of the loan, whether interest is payable and the dates for repayment;
- Specify what is to happen if the interest is not paid or repayment is delayed. You also need to agree what your rights will be if these events happen.
- Consider registering a mortgage or a caveat to secure the loan; and
- Ensure that each party to the loan agreement keeps a copy of the loan agreement in a safe and easily accessible place.
These suggestions may seem like overkill when you are dealing with friends or family and may be difficult to discuss initially, but if handled in the right way, with the approach that “these things protect both of us, not just me”, they may prove invaluable in the long run.
After all, nobody wants to be thought of as the third alternative in the categories of the three “F’s”.