Wednesday, May 05, 2010

FIN24: Bank of Mom and Dad: the rules

Original article from here.
Johannesburg – The credit crunch has dashed the hopes of many South Africans wanting to buy a home or start a business.

Despite a relaxation in recent months, banks’ lending criteria remain much stricter than a couple of years ago, with 100% home loans virtually disappearing for a large part of the market and the average deposit still above 20% of a property’s purchase price.

As a result, many people are turning to their parents or grandparents to borrow money, which may benefit all involved.

The potential downside?

Years of feuding if payments aren’t honoured, bitterness and bickering among siblings, financial devastation and fraught family dinners where everyone is nervously eyeing the exact position of the carving knife.

How to keep it friendly, while keeping it in the family:

* Establish whether the borrower can afford the loan.

“Given that there is significant evidence that banks are lending again, when credit applications get rejected, I believe that it will be linked mostly to affordability,” says Anton Gildenhuys, head of Sanlam Personal Finance Strategic Business Development.

The National Credit Act puts an obligation on banks to check whether the applicant can afford to pay back the loan.

“If the child is unable to obtain finance from the bank, the reason is quite likely to be an affordability concern. Borrowing from the family will not take this concern away, and chances are that the loan from the family will not be serviced either. This can easily lead to friction in the family, which should be avoided,” he says.

However, if the child is able to obtain finance from the bank but views the terms as rather punitive, Gildenhuys thinks it may make sense if the parents can increase the deposit to make the loan terms more attractive.

Prospective borrowers should present detailed budgets to family members to show whether they can afford to pay back a loan, and how much can realistically be paid back every month.

The budget and all other documents that show income and expenses should be provided, to ensure that the financial situation of the borrower is understood.

* Can the lender afford the loan?

Under no circumstances should you lend money if it means putting your own financial health at risk.

The lender should always prepare for the worst-case scenario: what will the impact be if I lose all of this money?

“If property is involved, are you sure that you will stand in line before other creditors?” asks Gildenhuys.

“I would imagine that unlike a bank, which has a mortgage registered against the bond, you will only recover funds once other creditors have sold all the assets and recovered their debt - which will likely be zero.”

Many parents increase their home loans to help fund their children’s property needs. While the interest on home loans is relatively low compared to other credit, remember that if your child can’t afford to cover the increase in your instalments and your own situation deteriorates, you may end up losing your own house.

There are also legal and administration costs involved when you increase your bond.

Also consider the exact opportunity cost of lending the money to a family member. If you plan to lend R50 000 over ten years (and if you could get a return of 8% a year on the money), you are in fact parting with almost R110 000.

An important issue is liquidity. With other investments, in shares or the money market for example, you can access your money easily in case of emergency. But when your money is tied up in a family loan, getting hold of cash quickly will be a problem.

* Draw up a loan agreement.

Van der Spuy Brink, director of the investment management firm Vega Capital, says he studied the topic of family finances, spoke to many people and followed the principles of the The Millionaire Next Door (by Thomas J. Stanley and William D. Danko) before deciding how to fund several university degrees, cars and even houses for his three daughters.

“The way we did it is to be fair to all my three daughters and sons- in-law and never to give handouts. The ultimate objective was to improve the self confidence of my children in the process.

"In our case we consulted an attorney and the possibilities of non-payment, death of the borrowing family and divorce were considered. We acted as a bank and registered a mortgage against the loan."

One of his sons-in-law, Marthinus van Schalkwyk, an engineer, thinks the biggest rule of inter-family lending is to keep it “cold and clinical” and “under a business umbrella”.

“There is a way in which both parties can leave the deal with a smile on their faces. If he (lender) can make money whilst he (receiver of the money) can save a few bucks you would have the perfect setup. It now becomes a business deal.”

A formal agreement should be drawn up before proceeding with a loan.

All the loan terms – including the amount, interest rate and the term – should be detailed. Look at the current interest rates on offer from banks to make sure that both parties are satisfied by the arrangement. Use online loan calculators to work out the exact repayment amounts.

The agreement should include a complete repayment schedule, with details on how and when money will be paid back.

There should be a record of every payment, and a signed receipt should be provided to the borrower.

Make provision for penalties or other consequences if the borrower falls behind on payments. The experts recommend avoiding “balloon payments” – large payments at the end of the term, and favour regular payments which will settle the whole amount over time.

You may want to include other personal stipulations, like when the loan may be discussed - not at family gatherings, but at regular intervals, in a meeting behind closed doors every six months, for example.

The signing of the agreement should be witnessed.

For large amounts, and if security is required, get help from a lawyer to draw up a document and to assist you with other legal issues.

* Donating instead?

As a general practice, children should not borrow money from anyone, least of all their parents, says Trixi Neethling of the Johannesburg law firm Roy Bregman Attorneys.

“Rather give the money to them, but do not lend it and expect to receive it back because once they are unable to repay the money their own feelings of inadequacies and your feelings of being let down will create an atmosphere that effectively spoils the relationship.”

When children require money from their parents, parents should make it clear that if the money is not repaid it will be deducted from their inheritance.

“This should be discussed in a family setting with all the other siblings and relevant persons around the table. It should be discussed in a neutral tone as a clear business transaction,” Neethling says.

The other important aspect is to record the terms of such an agreement in an acknowledgement of debt or other document, which is properly drawn up. “Then both parties know exactly where they stand and other siblings and possible heirs of the estate won’t have any reason to feel that they are being cheated out of their fair share,” she adds.

* Considering tax

There are a number of tax implications when it comes to an agreement between family members, particularly when interest is charged, and if the loan should be written off, says Gildenhuys.

“Make sure that your tax and other documentation is in order.”

Brink says his family had a detailed tax statement drawn up, which was cleared with their tax consultant.

Gildenhuys recommends treating the "loan" as a donation for all purposes in the lender’s financial planning.

When donating money, the first R100 000 a year is tax free. On amounts of more than R100 000, the donor will have to pay tax of 20%.

You can use donations of R100 000 a year to reduce the size of your estate so that your heirs pay less estate tax after your death. (Surviving spouses do not pay estate duty.)

Vicky gave her son Louis, a 37-year old graphic designer, R400 000 over four years as a deposit for his first property. He says the arrangement is “honour-based” and the idea is that he will pay off his bond quicker thanks to the deposit and smaller monthly instalments.

Once the bond is settled, he will start paying off her “loan” to him. However, the understanding is that should he not repay the whole amount, it will be deducted from his inheritance.

It is, however, important that both parties understand the terms and whether the money is a loan or a gift.

* Be fair. The same rules should apply to all the children in the family, says Van Schalkwyk.

They should also be aware of any financial agreement between a sibling and their parents, and parents should be prepared to offer a similar deal to their children.

No comments: