Understanding the risks of lending and borrowing

1 August 2016

UNDERSTANDING THE RISKS OF LENDING AND BORROWING

There are inherent risks in lending and borrowing money, and guaranteeing another person’s obligations under a loan agreement, which may lead to far-reaching consequences in the event of a default by the borrower or the third party security provider.

Before entering into a loan transaction, it is prudent for all parties to obtain independent legal and financial advice so that they understand the nature and effect of the transaction and develop strategies to reduce the likely risks involved.

Lenders:

• The loan agreement and any guarantee and indemnity document should be prepared properly to ensure that they are binding on the borrower and any guarantor, and entitle you to steps to recover the loan, interest and your legal costs in the event of a default.
• You should satisfy yourself as to the creditworthiness of the borrower.
• If you do not obtain adequate security from the borrower (such as a mortgage), you may not be able to recover the loan in the event of the borrower becoming insolvent.
• If the borrower is executing a mortgage, you should take reasonable steps to verify the borrower’s identity. Otherwise, the Registrar of Titles may refuse to register the mortgage or remove the mortgage from the register.
• You should be aware of any applicable limitation periods for commencing legal action against the borrower or guarantor. For example, if you lend money to family and friends on the basis that the loan will be repaid upon demand (i.e. with no specified repayment date), you will have six years from the date when the borrower receives the money to commence legal action for recovery (i.e. not from the date when you first make the demand).
• You should give the borrower and any guarantor the opportunity to seek independent legal and financial advice before signing any documents.
• There may be estate planning implications of lending or gifting money to your children.

Borrowers:

• There is no such thing as a standard loan agreement or mortgage so you should obtain independent legal and financial advice before entering into any loan transaction.
• You should consider your financial capacity to service the loan if there is a health crisis, relationship breakdown or death of a co-borrower.
• In the event of a default, you may be required to pay substantial legal costs incurred by the lender to recover the balance of the loan together with interest.
• If you wish to borrow a loan to invest in a property through your Self-Managed Super Fund, there are specific rules and restrictions governing such investments so it is prudent to obtain legal, financial and taxation advice before making a decision.

Guarantors:

• You should understand the difference between a guarantee and an indemnity and the consequences of a default by the borrower under the loan agreement.
• It is prudent for you to satisfy yourself about the viability of the transaction and the borrower’s ability to repay the loan to the lender.
• You should obtain independent legal advice in the absence of the lender and the borrower.
• Depending on the terms of the guarantee and indemnity, the lender may be entitled to recover moneys from you regardless of whether or not it has attempted to enforce its rights against the borrower.
• You may consider requiring the borrower to maintain income protection insurance to cover for loss of income in the event they are unable to work due to sickness or injury.

We can advise you in relation to these matters, including the validity of loan agreements and guarantees or indemnities, commencing or defending any legal proceedings, and estate planning.

For more information, please contact Eales & Mackenzie Commercial Lawyers Melbourne on (03) 8621 1000 or email advisors@emlawyers.com.au.

The contents of this publication, current at the date of publication set out above, are for reference purposes only. They do not constitute legal advice and should not be relied upon as such. Specific legal advice about your specific circumstances should always be sought separately before taking any action based on this publication.