Keeping a loan in the family can have its benefits, but beware unexpected pitfalls

WITH mortgages and credit increasingly hard to secure more people are turning to parents and other family members for financial help.

But sizeable gifts or loans to family members must be carefully structured to avoid future problems. Carole Hope and David Mowlem of Murray Beith Murray in Edinburgh share their top tips on lending or gifting money to family members.

1 THE LEGAL POSITION

This falls into two categories – the donor could make an outright gift or, alternatively, a loan. In the latter, the lender and borrower need to be clear about the terms of the loan at the outset.

2 RECORDING DETAILS

Not only will this help ensure that both parties understand the terms, but it will also act as a legal record should any proceedings be required in the event of the terms of the gift or loan being breached. For a substantial loan to help with a house purchase, the lender may want to take a security over the property. Remember, family members sometimes will fall out – and money is often the main cause.

3 SETTING OUT THE RULES

Loan agreement documentation should cover all eventualities, even if they seem remote at the outset. Matters that should be covered include the duration of the loan, the amount and, where applicable, the interest rate.

4 REPAYMENT DEFAULTS

Don't make assumptions or indulge in wishful thinking just because the borrower is "family" – the agreement should cover repayment default issues, such as the provision of a fixed penalty or interest charge.

5WHAT IF ONE PARTY DIES?Should the borrower die before the loan is repaid in full, the outstanding sum will form a debt and have to be repaid from the assets of his or her estate, funds permitting. Any secured debts, such as a borrower's mortgage, will be repaid from the estate assets first, with the effect that, in some cases, an unsecured loan will not be able to be repaid in full.

If the lender dies during the loan period, it will form an asset in his or her estate, and the right of recovery will generally fall to his or her executors. The precise details should be covered by the loan agreement documentation. Even when a loan is within a family, HM Revenue & Customs will want to know of any interest received as it will probably be liable for taxation as income.

6 ENCOURAGING PRUDENCE

At the outset, the borrower should ensure that the loan repayments can be comfortably met from his or her disposable income, bearing in mind that their circumstances might change. If the interest rate on the loan is not fixed, the lender may have no alternative but to increase the interest charges should the Bank of England base rate change appreciably.

7 BUSINESS FINANCE HELP

Before making a loan to buy a trading business or start a new business venture, ensure the family member borrowing the money has an understanding of the business model and the risks involved. It is advisable that both the borrower and lender seek separate legal advice in order to ensure they are aware of the risks.

8 ACTING AS GUARANTOR

Some people who are unable or unwilling to lend money themselves may be prepared to act as a guarantor for a close relative taking out a loan through a bank or finance company. In this case, the guarantor would become responsible for the outstanding balance of the loan should the borrower default.

9 SHOULD YOU CHARGE INTEREST?

This is a matter for each particular family to agree upon. The interest rate selected is likely to be significantly lower than any personal loans available on the market, so may still represent an attractive option. If no interest is charged there will be a net loss to the lender's estate over time, taking into account the effects of inflation. The interest rate, if any, should be specified clearly at the outset and recorded in the loan agreement to ensure that both parties are aware of the terms and therefore reduce the possibility of disputes in the future.

10 EMOTIONS AND FINANCIAL REALITY

A family loan is more than a business transaction and personal issues can make the arrangement more complicated.

Relationships can end on a sour note, holidays can be awkward, and the wider family can be adversely affected if the loan goes "bad". In order to minimise the chances of this it is important that both parties are open about everything. When entering into the loan, each should be clear of the terms and also make their overall objectives known. In addition, the borrower should be clear about his or her financial situation. Good communication throughout the duration of the loan is the key.