Think Twice Before Borrowing Money From Relatives

Generous Uncle George offers you a loan for a big purchase. Should you accept?

Think Twice Before Borrowing Money From Relatives

So it’s time to get expand the business, upgrade your shop or purchase a major piece of equipment. “About $50,000 ought to cover it,” you whisper to yourself when you’ve pulled all the information together.

Unless you’ve been really lucky, you’re not going to pay cash in full for it. Not to say you couldn’t afford to, but the fact is, if you can afford the cost of borrowing, even for a short time, it often makes sense to use credit and avoid tying up too much cash that you might need for other expenses — especially unexpected ones.

So the next step is financing. Your business bank is usually the ideal source for a loan. But those involve paperwork. And there may be any number of reasons that the loan officer looks at you sideways and decides you don’t quite qualify for their lowest rate — even if your credit score and repayment record are spotless.

Then along comes your wealthy Uncle George. He’s always been kind of proud of how you’ve built your business with your own two hands. And when Uncle George offers to lend you the money on the spot, it’s hard not to shout “YES! THANK YOU!” right away, shake Uncle George’s hand, and promise you’ll pay him back.

But should you take the money?


Proceed Slowly

Rob deJong is managing partner with the Milwaukee, Wisconsin, law firm of Rose & deJong, where he handles all kinds of transactions for small- to midmarket companies. His advice? Think twice.

“Loans between family members are fraught with potential downfalls,” deJong points out. “I would tell Uncle George to make the loan only if a complete loss wouldn’t change his view of the borrower and it wouldn’t change his life.”

His cautionary stance applies to both sides of the deal. “I would tell Mr. Business Owner to decline out of hand if he could borrow the money from a bank or financial institution,” deJong says.

The reality, though, is that these transactions happen — a lot. Then what?


Lawyer Up

Suppose Uncle George has money to burn and is willing to take the risk — and that you are comfortable letting Uncle George be your loan officer. What’s the next step?

“Everyone needs a lawyer, because they have different, conflicting interests,” deJong says. “But at the very minimum, Uncle George needs someone who can draw up a legally binding agreement.”

Yes, it’s tempting to skip the paid advice. After all, it seems so straightforward — five years to repay, 9% interest — how complicated can it be?

Answer: You don’t even know — and the protection you buy by employing an attorney in the deal is inexpensive insurance.

“Documenting a loan like this is a relatively easy, low-cost thing for a lawyer to do,” deJong points out. “On the other hand, doing it incorrectly can be costly for both borrower and lender.”

The contract should provide for certain kinds of protection for both you and Uncle George, deJong explains.

“The documentation should be crystal clear that the money is owed with any deductions and the principal accelerates upon a default in a regular payment,” he explains. “It should also provide that Uncle George can add his legal fees to the total if he has to sue to collect payment.”


Check the Market

Before you get an agreement drawn up, both you and Uncle George should have an idea of fair interest rates and a reasonable time for repayment. Check with your local bank and credit union.

The agreement also needs language that’s clear on what the loan collateral is and on the general terms of the loan. “The collateral — a lien on the store or whatever — must be properly documented,” says deJong.

We’d hate to think we’d have to look for fine print in a transaction with a relative, but deJong warns, “Also, watch out for any prepayment penalties, should Mr. Business Owner decide to pay off the loan early.”

Another good reason to involve a lawyer is state-by-state differences concerning the terms of business loans. “For business transactions (as opposed to consumer transactions), there is no limit on the amount of interest to be charged in Wisconsin,” deJong gives an example governing loans in his home state.

Every state will have slightly different provisions, and the underlying assumption is often that business owners need fewer protections than ordinary consumers.


Cover the ‘What Ifs’

Last, but hardly least, what happens if you can’t repay the money?

For any other lender, the typical remedy is that if you get too far behind on your payments, you lose the collateral. So if Uncle George has taken a strictly business approach to your deal — as, arguably, he should — he’d have the right to put a lien on your store.

So, as with any other lender, you want to be sure he can’t take away any of your other assets. That includes business assets and any personal assets, such as your house. To guard against that, the loan absolutely should be made to your business, not to you personally. And that also means there should be no personal guarantee.

“If the loan is to an entity like a corporation or limited liability company, the obligation to repay the loan stays with the entity,” says deJong.

The contract should also make clear that the agreed-upon collateral is the only collateral included. None of your other equipment, supplies or inventory should be mentioned.

All of which adds up to this: You might think borrowing from a relative would involve a lot less bureaucracy and paperwork. But if you do it right, it won’t — and a lot of that bureaucracy and paperwork is for everyone’s protection.

So — borrow from a family member? In general, you’re going to be better off just saying no. But if everything adds up to tell you that, yes, that’s really the best option, then make it as businesslike a transaction as possible.


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