Depending on the needs and preferences of the lender and the borrower, informal loans can be administrated in a number of ways. YourMoney.com spoke to two legal experts about key considerations for informal lending.

Initial concerns

It’s important to think about why you’re lending. While in your case it’s elective, some can feel directly or indirectly pressured into handing over money. If you are offering a loan for any reason other than because you want to, don’t lend.

While it may seem obvious, bear in mind the financial ramifications if the borrower cannot repay the loan.

“Consider the impact losing the amount lent would affect you – whether it’s your ability to meet financial objectives, or cope in an emergency,” says Marilyn Stowe of Stowe Family Law.

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Set boundaries

Clear and open communication between you and the borrower will help ensure the transaction goes smoothly and painlessly.

“It’s important to establish boundaries – for the sake of clarity, and to ensure the loan is transacted stress-free,” says Stowe.

A misunderstanding of the terms of the informal loan on either of your parts could be a recipe for disaster. The borrower may think, for example, the loan can be paid back whenever, or in instalments as and when they can, when you require it to be paid back within a certain timeframe. They may even mistake the loan for a gift.

You may also be lending the money for a specific purpose, such as purchasing property. If this is the case, you may wish to supply the money to the seller directly, to ensure it reaches its intended destination – and that you are strictly covering the cost.

“If you’re offering a loan for such a purpose, you should formalise it too,” Stowe adds.

She recommends securing a loan agreement between yourself and the borrower, which codifies the repayment terms – including timings, interest due and what happens in the event of a default – in a written document.

“It’s possible to stipulate penalties for late or missed payments – and what happens if the lender or borrower dies before the loan is repaid,” she says.

Judith Fitton of family law firm Mundays believes all informal loans should be put in writing.

“If there is no document, the borrower could say in future the loan was just a gift and does not need to be repaid at all,” she warns.

This is especially important if the borrower defaults, and you pursue redress through the small claims court.

“Courts view loans from family members as ‘soft’ loans which may not always require repayment. In contrast, a loan evidenced by a formal agreement is considered a ‘commercial’ loan, its repayment factored into any order or settlement,” Fitton says.

Click here for a customisable loan agreement template.

Hidden dangers

Fitton says non-formalised loans could pass out of the borrower’s hands in whole or in part, in the event of separation or divorce.

“If you’ve helped buy your child a house, their partner could make a claim on that investment,” she explains.

“You may never see the money again – and it could be diverted away from the very person you were trying to help in the first place.”

Fitton recommends that those lending to married relatives or friends request the borrower seeks a postnuptial agreement that recognises the loan, and ensures the partner waives claims to it in the event of a separation or divorce.

“Such agreements have not yet made it onto the statute books, but the Courts are likely to take the terms of the agreement into account as a factor of significance when considering what financial orders should be made.”

Stowe warns a parent’s money could be at risk of a claim even if their child is unmarried but living with a partner. She recommends couples enter cohabitation agreements, which set out precisely the assets each partner holds in a relationship – and how they should be divided in the event of the relationship ending.

“These agreements can be decisive in ensuring the money stays with the borrower – and, ultimately, the lender,” says Stowe.

It’s also important for lenders to bear in mind the potential tax implications.

“If a lender receives any interest on a loan, this may be taxable as income – they must declare it on their self-assessment form,” she concludes.

Alternatives

While lending money to family and friends may seem like the right thing to do, fallings out, high costs and legal headaches are common. A 2014 Scottish Friendly study found that seven million Brits had lost contact with friends or family due to a financial dispute.

Of course, not every informal loan ends in tears for those involved. Still, you may both decide that it’s more trouble than it’s worth, and wish to consider alternative lending platforms – such as credit unions, or peer-to-peer loans.

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