We often receive questions from clients who are thinking about loaning money to a friend, family member or business associate, or are thinking about co-signing a loan with them. Sometimes our clients are thinking about “seller-financing” someone else’s purchase of real estate or a vehicle they own. In these situations, our clients are putting themselves in the position of a traditional bank or other lender and their questions revolve around “Should I do it?” and, if so, “What should I do to protect myself?” Our advice in these situations is always the same: “If you’re going to be the ‘bank’ in this transaction, you have to do things the way a bank does them.”
When we tell folks they should “do the things that a bank does” we’re telling them to approach the potential transaction from an objective, business-like perspective. Banks make decisions about extending credit based on the likelihood that they will be repaid in full and with interest, and they evaluate potential borrowers based on what the bank believes is their ability to repay the loan (this is the foundation of credit reporting and scoring). This evaluation process includes gathering information about the borrower, checking credit reports, asking for references, etc. Another part of the evaluation process is determining if the potential borrower has enough equity or “skin in the game” in a potential transaction to ensure that they won’t walk away from an obligation to repay borrowed money. For instance, if a borrower doesn’t pay a down payment on the purchase of a vehicle and borrows the entire purchase price, if soon after the purchase they decide to walk away from the vehicle, they have nothing to lose.
Once a bank has made a decision to make a loan, they use legal documents which help protect the bank from the risk that the borrower will stop repaying or “default” on the loan. These documents include promissory notes (contracts to loan and repay money), and security instruments, which make personal property or real estate “collateral” or “security” for the loan (these can include liens, deeds of trust, security agreements, etc.). An individual who makes the decision to loan money, co-sign, seller finance, etc. needs to use the same type of documents to protect themselves. Our firm can help you put these documents in place so that you have the best possible chance of being re-paid.
Ask Yourself: “Why Are We In This Situation?”
Keep in mind that, if you are in a situation where someone is asking you to take a financial risk to help them, it’s likely because they are unable to borrow on traditional terms from a traditional financial institution. With very few exceptions (mainly young adults who haven’t yet established credit), this is because a bank views the individual as too much of a credit risk to make the loan. Be sure to think long and hard about whether you are willing to take a risk that a bank is unwilling to take. Often the situation is made more complicated due to some close personal relationship between you and the potential borrower. While it’s difficult, we suggest that you try to be as objective as possible in these situations. If you’re in such a situation, please don’t hesitate to call Coltrane, Grubbs & Orenstein to help you navigate the decision-making process.