Whether you’d like to lend money to help a family member or as a commercial venture, there are some important guidelines to be aware of. Not only can lending be a risky undertaking, but there are laws that govern how it must be done. Universal lending legislation does not exist. It varies from place to place.
In this article, I will assume that you have already made the decision to grant somebody a loan. You’re now looking for how to do it legally and effectively. I won’t bother addressing the potential risks or upsides here. Rather, I will try to offer solutions to help ensure that your money is as safe as can be.
Use a Contract (no exceptions)
You must formalize your loan agreement, regardless of how awkward either party may feel about it. Here’s why:
- It will help avoid confusion and misunderstandings. Having a contract is a way to protect your relationship with the borrower and avert uncomfortable discussions.
- It will make disputes easier to resolve in court if the transaction takes a turn for the worse.
- It will make your accounting simpler.
- It will serve as evidence if you or the other party are ever audited. Otherwise, both parties risk facing questions over whether the loan was a gift, rather than a sum that must be repaid. That can come with significant tax consequences.
What to Include in the Contract
Below are the most basic components to a loan agreement:
- The loan amount (principal).
- The interest rate (usually expressed as an annual percentage, like “6% per year”).
- The term (when the loan must be repaid).
- The payment schedule (how often the borrower must make payments and in what amount).
However, you may want to think of other questions that may arise. Then, try to include answers to them in the contract. For example:
- What happens if the borrower is late with a payment? Will there be late fees?
- Do you live in a different city from the borrower? If so, where will legal action take place if a dispute arises?
- Is each party aware of what they are signing? To be sure, you may want to include a clause that states that each party has had the opportunity to seek independent legal and financial advice before executing the loan agreement.
It’s useful to have a witness to your agreement. Conversely, you can also use online execution software, like DocuSign, to sign your contract.
Should You Use a Lawyer?
The short answer is yes. You should always seek legal advice before lending money. A lawyer will not only advise you, but they will also draw up sufficient documentation to ensure the validity of your loan. This is crucial if you want to ensure that you are lending money legally.
It is standard practice for the borrower to reimburse you for your professional expenses. This is typically done by deducting those costs from the funds advanced to the borrower. It may look like this, for example:
- The loan agreement shows a debt of $30,000.
- Your lawyer charged you $1,000.
- You give the borrower $29,000.
Generally, taking collateral means that the borrower cannot sell a particular asset without first repaying you. This occurs once the borrower has granted you a security interest in it. Common types of collateral are:
- Real estate (e.g. placing a mortgage on the borrower’s home).
- Machinery and equipment.
If you plan to take security for your loan, then it is especially important to engage the services of a lawyer. Lending regulations often become more complex when collateral is involved. In many jurisdictions, the use of a lawyer by both the lender and the borrower is required by law.
Proceeding without a Lawyer
However, you may not feel that the time or expense of working with a lawyer is worth it — especially if the amount you’d like to lend is relatively small and it is unsecured. Perhaps you just want to lend a friend $500 to help start his business, for instance. In that case, at a bare minimum, you should search online for answers to the following questions:
- What are the lending laws in your city/province/state/country?
- Do you need a license to lend money?
- What is the maximum interest rate you can charge?
- Are you required to provide disclosures (account statements, etc.) to your borrower?
Government websites will be your most trustworthy sources of information. But you might also land on articles written by lawyers which can be of help, too. Just be sure that they are up to date.
To be clear: your risk will increase substantially if you choose not to involve a lawyer.
Basic Due Diligence
It is necessary to research your borrower’s ability to repay you. Otherwise, you won’t have a way of knowing how risky lending to them might be. Here are some documents you might ask for in advance:
- A summary (and evidence) of all their existing assets and debts.
- A signed statement from the borrower that they have disclosed all assets and debts to you, that they are not involved in or expecting any litigation, and that they do not intend to file for bankruptcy in the near future.
- Their tax return from last year.
- Recent pay stubs.
Other Things to Know Before Lending Money
- If you are going to place a mortgage on the borrower’s real estate, be sure to know the loan-to-value ratio. You way want verification of the property value (e.g. property tax assessment, appraisal, realtor’s opinion).
- If the borrower files for bankruptcy, then you may lose all of your money.
- If the borrower lied to you and committed fraud to get a loan from you, then the borrower might not be able to discharge that debt through bankruptcy.
- If the borrower files a Consumer Proposal, then you may lose a lot of your money.
- If the borrower dies, then you may need to sue their estate to recover your money.
- Legal action can take time. Even if you win in court and receive a judgement, the borrower can try to shift money around to avoid paying you. Be prepared to jump through some hoops.
- It is useful to have a co-signer. Not only can this increase your security, but it can serve as additional incentive to pay you back. The borrower will likely want to unburden their cosigner as quickly as possible.
- Oftentimes, people are friendly when they want money from you, but will be resentful when they owe you.
I am a lender, myself. I can tell you that lending money is serious business. It is also not a practice that can be summed up in a single article. You would be well served to speak with a licensed financial advisor and a lawyer before lending money to anyone.