Andy Jervis, one of our Directors, explores an important question...A client called me recently for my advice. Friends of hers were struggling to find the money to buy their home, and she was considering making them a loan. Should she help?
I asked for a bit more information. Apparently, her friends were approaching retirement and were living in rented accommodation. They had mentioned to her that they had been looking to buy their own home to give them more security in retirement, but had been unable to find a mortgage lender willing to help them. My client had significant funds in cash earning “diddly squat” and felt that this would be a way to make better use of her money and to help out a close friend at the same time.
Will your friendship survive your agreement?
There is no reason why you could not make a loan in these circumstances, and it’s quite common for family members to help out their offspring in this way (The National Bank of Mum and Dad!). However, I pointed out that making such a loan could cause a whole heap of trouble, and before you decide there are some questions that you need to ask yourself. Here’s a summary;
Why can’t they find the money themselves?
If you are thinking of lending to a young person, then maybe they haven’t yet had an opportunity to accumulate sufficient funds to be able to consider a house purchase. Helping them out with a deposit might be a great way to kickstart their financial life.
But if your friends are later in life, you might wish to ask yourself (or them!) why, unlike you, they are in this position? Is it just a run of bad luck that’s left them financially bereft, or is it a sign of a lack of ability to control their finances and put money aside for the things that are important to them? Even worse, are they in debt and in denial about their financial reality?
There is always a reason why mortgage lenders will not advance money to some people, either because of their credit record or inability to repay the loan in their current circumstances. At one time, their age may have been a good reason, but lenders attitudes have relaxed in recent years and most will provide mortgages up to age 75 and beyond. Try to find out what the mortgage company knows about your friend that you haven’t yet seen, or have chosen to ignore.
Do you expect to get the money back?
If you see this as an investment opportunity then you will need to lay out clear expectations about how and when the money will be repaid. If this money is important to your own financial future, you’ll need to work out when you expect to get it back. Most mortgage loans are arranged for periods of 25 years or more simply because spreading the loan over a long term makes the monthly repayments more affordable from the start. Can you wait that long?
On the other hand, you may take the view that you can afford to lose this money, and that’s a risk that you are comfortable with. Before you lend it, be clear in your own mind about where you stand on this.
How much interest will you charge?
If you are lending a sizeable sum and you are treating this as an investment, then you will want to charge some interest. There is nothing to stop you from doing so at a rate to be agreed between you, and there are various financial calculators available online that will allow you to work out the repayments based on different rates of interest. Bear in mind that any interest that you receive will be potentially taxable and you will need to declare it to HMRC every year. So you’ll need to keep good records.
How will you keep track of the loan?
Speaking of good records, you will need to be on top of the paperwork when it comes to accounting for the amount of money that’s been repaid, how much of that is interest and how much loan repayment, and what is the outstanding balance at any one time. If you aren’t familiar with this kind of financial accounting then you need to find someone who can do it for you.
What security will you have for the loan?
Mortgage lenders will normally take a ‘first charge’ over a property as security for their money. This means that, in the event that the property is sold, they will be entitled to repayment of the outstanding loan together with any related costs associated with it. If you are going to advance a sum of any size then it makes sense to do the same by registering a charge against the property. Bear in mind that if there is already a mortgage on the property then you will probably need to take a ‘second charge’ which means that you will only be entitled to proceeds from any property sale after the holder of the first charge has been satisfied.
Do you need a written loan agreement?
If you are not charging any interest, are relaxed about whether or not you ever get your money back, and are happy to write the loan off in the event of your death, then you could get by without a written agreement, but even in these limited circumstances then I still recommend that you have one drawn up.
Your agreement needs to cover the basis of repayment, how much the loan will cost including any interest, the nature of any security such as a charge on the property, what happens if the borrower wants to repay some or all of the loan, your rights if the loan isn’t repaid, and what happens if you need your money back. You will almost certainly need a competent solicitor to do this for you to make sure that you cover all of the essential points.
What happens if your friend fails to make repayments?
Here’s where we start to get into difficulties. Countless solid friendships have been torn apart by entering into financial arrangements that went sour.
If repayments aren’t made then you’ll need to be able to provide some leeway to your friend to help them through a difficult time, but ultimately you will have the security of your charge on their property to fall back on. However, to take advantage of this means that you will need to force the sale of their home to repay the loan. Are you ready for this? Will your friendship stand such action? Do you have the resolve to carry it through? Or is your relationship such that you would have to grin and bear it until they either got back onto an even keel or decided to move on themselves? Can you wait until they die before you get your money back?
Will your friendship survive your financial arrangements?
Helping your friend may be a great way to cement your relationship in the early stages, but are you prepared for the awkward situations that can arise when one of you is in debt to the other? In trying to do the best thing for your friend, you might find that the dynamic of your relationship changes in a way that you didn’t anticipate. This is especially true if things start to go wrong. Will your friend feel able to be open and honest about their difficulties, or will they be too embarrassed to discuss it?
Is this really the best way to help your friend?
Sometimes what appears to be a valuable helping hand can be an easy way out for someone who isn’t prepared to face the reality of their circumstances. Much as you want to help, there are times when the only way to learn is to go through the experience of having to deal with getting your finances under control.
Are there other ways you could help?
Before you lend money, are there other areas in which you can provide valuable assistance without tying yourself into a commitment that you might regret? For example, would your friend benefit from some advice about budgeting and saving, so that they can be better able to build a deposit and approach a mainstream lender? Do they understand how much they could borrow, and the implications of entering into a long-term commitment like a mortgage? Indeed, could they be better off with the flexibility and lower commitment of renting or finding an alternative place to live?
Even though you want to be a good person and feel the love from your friend or relation for having helped them in their time of need, my advice is to tread very carefully before you make an offer that you might later regret. Sometimes it’s in their own best interests to help them to find a way through using their own resources.
I would be interested to know if you had any experiences of lending money to friends or family, and what happened. Tell me your stories at email@example.com
especially if other people might learn from them.
Director of Woodgate Financial Planning