Pitfalls of lending to family and friends
With the challenging property market for first time buyers, and the poor returns available with more traditional forms of investment and saving vehicles, it is now becoming increasingly common for parents and grandparents to loan money to their children and grandchildren. This could be for a variety of reasons, from funding house purchases to new business ventures.
A surprisingly large proportion of those who lend money to family or friends have not discussed how the loan will be repaid and when, or considered the risks of not getting their money back at all. Furthermore, while there is much talk of the detrimental effect on personal relationships when lending money to friends and family there is little thought to the legal ramifications of doing so.
A common enquiry I receive goes something like “My son or daughter are purchasing a property and I wish to loan them £XX,XXX.XX for the purchase. Please can you draw up a simple form of loan agreement?”
This seemingly straightforward enquiry will result in numerous responses from me. The most important being “yes I would be delighted to help” and “yes I can draw up an agreement”. The other responses may not be so obvious but are crucially important (and in no particular order):
1. Is the loan to be secured or unsecured?
- It is advisable when loaning substantial amounts of money that the loan is “secured”. Typically this means taking a legal mortgage (also commonly referred to as a legal charge) over the property. The property is your security for getting paid. This means should the worst happen and the borrower is unable to repay the loan you are more likely to get your money back. Your recourse is having the ability to sell the property yourself to recoup the loan and pay any balance back to the borrower. This is how high street banks commonly loan money.
- If a loan is “unsecured” should the worst happen you may not get all your money back, or any at all if the borrower does not have the money to repay the loan.
2. What is the purpose of the loan? The most common reasons I am given for making a loan are either to help a relative to purchase a home or to invest in their relative’s property business.
If you wish to secure the loan against the borrower’s home and are looking for a return on your loan by charging interest you will be committing a criminal offence if you do not obtain authorisation from the Financial Conduct Authority (FCA). Furthermore, a lack of authorisation will mean the loan will be unenforceable against the borrower so you would have no legal recourse to get your money back.
Lending money to be secured on property for renovation, and thereafter for selling or letting, is a much simpler prospect as authorisation with the FCA is not required. Why? Because this is considered as lending money for the borrower’s business purposes and is exempt from regulation. You can agree whatever terms with the borrower you wish.
3. Is the loan to individual(s) or a company? This distinction is important because loans to consumers (which includes individuals, partnerships and unincorporated associations) may be caught by the Consumer Credit Act 1974 (as amended) with the result that in order to make the loan you would need to be authorised by the FCA. You would be committing a criminal offence to proceed with the loan without such authorisation and the terms of any loan agreement would be unenforceable. There are exemptions and it is my job to see whether the loan can be made within one of those exemptions.
Whatever you decide it is important to make sure that the terms of the loan are clear and are set out in writing.
As a recap, you need to be clear on:
- To whom the loan is to be made
- The purpose of the loan
- How the loan is to be repaid (i.e. by instalments or in one lump sum)
- When you want your money back
- How will the borrower pay you back (i.e. can they afford the loan)
- Whether you want to charge interest on the loan
- Do you require security for the loan (i.e. a legal charge).