The pitfalls of personal lending

CATHERINE HARRIS
Last updated 05:00 16/08/2014

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In Pacific culture, money between family and friends flows as freely as water.

It's expected that your relatives will financially help you out, and it is a largely alien concept to expect money back, says the Pacific Island Affairs Minister, Peseta Sam Lotu-liga.

"I know you use the term lending, but we call it gifting. There is lending obviously between people, but a lot of what goes on between family members, you assist and help where you can.

"Sometimes it has been the expectation that money's to be returned, but I wouldn't say it would be a legally enforceable contract between two people ... That's how you show your love for your relatives, not just with objects or time, but with money."

Pacific Islanders might just have the right attitude, because many times when people come up short for money and turn to their relatives, expectations don't match reality.

Kelly McCullough, a property lawyer at Howick's Fencible Law, sees a variety of family lending situations.

''We often come across parents and children buying property together, pooling resources to get bigger properties for them all.

"We've got children buying into their parents' houses to free up equity to avoid reverse mortgages; personal loans which may not involve real estate, it may be for other debt; and then you've got the ones where people are taking on a guarantor obligation."

Guarantees

If you decide to go ahead and make a loan, you have several avenues open to you, one of which is being a guarantor.

This simply means you guarantee you will pay the borrower's debt if they can't meet their obligations.

Offering a guarantee had its advantages, for example, if you have equity in a property, it does not require you to sell up (unless the borrower defaults).

Guarantees are often requested by banks when people are buying a house, especially at the moment when first-home buyers cannot quite get over the LVR banking hurdles.

However, there are also many horror stories of where guarantors have been chased for a payment they were not well informed about, or which goes well beyond their original loan.

To limit your liability, it's important to put a ceiling on the amount you guarantee.

"Bear in mind that a limited guarantee is still inclusive of any interest and costs of recovery," McCullough adds.

If a bank starts to add default interest and court costs to the mix, your limit can quickly blow out.

It is also important to know that if things go wrong, the bank is not required to sue the borrower first, and it often will go for the person whose assets are most easily liquidated. That could be you.

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The main difficulty with a guarantee is that you then have no direct control on whether the borrower keeps up their repayments, McCullough says.

"And the reality is, that if as a guarantor you've been called upon to pay, then the likelihood of you recovering whatever you have to pay from the person who should have paid it in the first place, is low."

Caveats and charges

A slightly safer solution is to seek some form of security. Where property is involved, that might mean a caveat on the property being sold or the one that is being bought. A caveat stops the property being sold without the debt to you being addressed.

But McCullough says a debt is not necessarily enough to register a caveat. It may require "an agreement to mortgage" which gives you as a lender, an interest in their property.

Putting a mortgage over another person's land when you know them well can be a ticklish thing. If they default, you have the right to enforce a mortgagee sale but would you really want to?

Another way of doing things, especially in the case of business loans, is to seek a share in the company or property. This may require tweaking a title.

Reverse equity lending

In theory, it is a great thing to give your cash-poor parents some money by taking a share in their house, and avoiding the interest that accrues on a reverse equity mortgage from the bank.

In practicality, there are issues that must be made clear, such as the valuation of the stake.

''If they go on a GV and the GV's much lower than a registered value, then the other children are going to get upset with the fact that that sort of does them out of their inheritance," McCullough says.

"The main point is if there's more than one child, then it has to be a fair market value, or the children need to be party to the arrangement."

Personal loans

Personal loans for debt other than a property are generally not recommended by McCullough's firm.

"It's very difficult. That would be the one where we generally advise to steer clear of that sort of family arrangement because there are few protections you can put in place."

As with property loans, you can request a simple debenture, a document indicating that a debt is owed and will be paid.

However, if it is simply against a person, and that person goes bankrupt, your loan and your relationship could be at risk.

You could try and secure your debt against assets they own such as a boat or car.

But it is worth checking that there are no others such as a finance company in line.

The fine details

After deciding which form of loan you want to make, the next difficult decision is whether to charge interest.

Some people find this too hard. Others consider it fair because of the "opportunity cost". That is, they are missing out on interest they would otherwise receive or the ability to invest in a better deal elsewhere.

Whatever contract you draw up should state some basic details, such as when the debt will be paid (eg. on the sale of a property), whether you will receive interest, how much interest and how often it should be paid. Your contract should also include a clause about what will happen if the money is not repaid.

Needless to say, you should probably run all this through a lawyer although there are some self-help documents on the web.

Alternatives to repayment

One alternative to onerous interest is to request repayments in kind rather than cash. One example given on the Internet is the story of a mother who lent her daughter money for a car. The terms of the loan was 100 hours of housework. The daughter only had to do two hours a week of tidying up and her mother got to put her legs up.

Or you could go the Pacific way. Because they expect to have to give money away quite often, some Island families actually budget for it.

"Because the problem is if you have two or three funerals in one week, and say you give $100 per funeral, a $300 hit is really hard in one week," says Lotu-liga.

''You put it in an independent account with two signatories so it doesn't go for a walk.

"So the next week if you have no fa'alavelave [family contributions] then it compounds."

Balancing the budget alongside family loans is something all families grapple with, Lotu-liga says, but in Pacific culture, there's the wider view.

You need provide for your immediate family but also your wider family because ''you have a meaningful role to play in your community".

Principles for lending

* Don't lend more than you can afford to lose.

* Write it down, preferably through a lawyer. Details you have discussed may not be remembered and, because they are verbal, won't be enforceable.

* State a limit on the amount you are lending

- Stuff

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