• ASAP Lawyers

Why is it Important to have a Loan Agreement?

It is essential that a formal loan agreement be entered by parties intending to lend or borrow money. It is critical that all parties to the transaction understand their rights and obligations as advancing money is never without risk. Care needs to be taken to ensure that the essential terms of the loan agreement are reduced to writing and that neither party is under any misapprehension as to how the transaction is to proceed.

As a minimum, a loan agreement should set out:

  • The amount of money lent

  • Any interest to be paid

  • The amount and timing of repayments

Two parties shaking hands over a table of documents
  • The security to be provided

  • Whether the security property be dealt with (transferred to a third party or further encumbered)

  • What happens in the event of default?

  • Whether the loan agreement needs to meet the test of being an arm’s length commercial arrangement.

There are many options around what type of security is to be provided and these include:

  1. Some people advance funds without security and merely require an agreement to evidence the existence of a loan. The loan will provide clarity as to the fact of the loan and will provide an evidentiary basis for a person’s estate or for recovery of the debt during the lender’s lifetime. The lender is provided with contractual rights (as opposed to proprietary rights) to evidence and secure the loan.

  2. Some lenders opt to obtain mortgage security over real estate. A mortgage gives optimal security by providing priority over other subsequent claimants and provides the lender with a proprietary interest to secure the loan. The drawbacks here are the cost of setting up the mortgage and, where the mortgage is a second mortgage, the need to obtain the consent of the first mortgagee, consent which may or may not be forthcoming.

  3. A loan agreement can also grant the lender a charge over the security property and that charge can be secured by a caveat. Whilst a caveat lacks the force and ranking of a registered mortgagee, it means that no one can deal with the property without the lender being notified.

  4. The lodging of a caveat, as noted, provides a level of security. In some situations, a loan agreement states that the borrower mortgages the property to the lender and the lender lodges a caveat to protect its rights as a mortgagee without lodging a mortgage unless or until the lender feels the need. Such a need might arise when the borrower starts struggling to make repayments or is getting into financial difficulty.

Entering a loan agreement with no security leaves the lender exposed to the risk of losing funds if:

  1. The borrower defaults on a first mortgage (say with a bank) and the property is sold by that bank (often without much regard for lower-ranked creditors);

  2. The borrower becomes insolvent and a trustee in bankruptcy (or liquidator or administrator) is appointed;

  3. The lender borrows further funds against the property with registered securities; or

  4. The parties become involved in family law or commercial disputes and the lender finds itself competing with other creditors.

Intra-family loans are becoming increasingly problematic. If the loan is not documented, is not secured so as to protect the lender or is couched in terms that are deemed not to represent arm’s length commercial arrangements, the lender (who is typically a parent) can lose out badly should the borrower become embroiled in family law litigation. Recent decisions have displayed a reluctance on the part of courts to honour (intra-family) loans that are either undocumented or documented in a form that courts believe does not represent commercially usual terms. In such cases, the advances have been deemed gifts with no obligation to repay.

It is essential that all parties to a loan, whether lending or borrowing money, consider their positions and the associated risks. ASAP Lawyers regularly accept instructions to advise and draft loan agreements. Contact us on 03 9450 9400 to speak with one of our lawyers.

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