More than ever, young people are relying on the ‘bank of Mum and Dad’ to get a leg-up. Whether it’s to break into the property market or utilise some initial capital to get their new business off the ground, we are seeing more and more of our clients give (and more of their children receive!) related-party loans.
A question we get asked often by the ‘lender’ in this scenario is whether it is possible for a loan to be advanced without the lender receiving periodic interest repayments, and instead receiving a share of the ‘upside’ (gain) when the financed asset is sold.
Our answer? Yes! You need an equity loan!
Some context on loans
Usually a loan involves:
- The advance of a sum of cash;
- The payment of interest while the cash is outstanding, to compensate for the time value of money; and
- The eventual repayment of the original amount advanced.
Most loans involve the amount advanced being paid back in instalments over the term of the loan, along with the periodic payment of interest.
However, often in related-party loan arrangements, payments of interest and repayments of principal, are not planned (or may not even expected).
For example, consider a scenario where parents lend a child money to assist them buy a house or start a business.
In this case, the parents expect to get their money back at some stage, but the advance is closer to a ‘co-investment’ with their child, rather than a loan.
Instead of receiving ongoing repayments of principal and interest, the parents might be inclined to ‘sit’ on their investment and then have the right to receive a share of the gain that arises on the eventual sale or disposal of the house or business, proportionate to their investment (being the amount they originally loaned).
This sort of arrangement can be documented in an Equity Loan Agreement.
So, what does this entail and how do the parents know that this kind of loan is best for their circumstances? Find out below.
What is an equity loan?
An equity loan agreement is like a standard loan agreement, whereby a sum is advanced by the lender to the borrower and in exchange, the lender receives the right to take security for the loaned amount against the property in the form of a registered mortgage or some other security. If it is a loan ‘facility’, then the agreement will set out the facility limit, being the total amount that the lender has agreed to loan the borrower. The lender can then make advances to the borrower as required. The facility limit can be changed with both parties’ consent as well.
What sets an equity loan apart from a standard loan agreement is how the lender receives their return. Curious? Keep reading!
What is the difference between a standard loan and an equity loan?
The difference is that instead of requiring periodic interest and principal repayments (per a standard loan), the equity loan provides the lender with the right to receive a return in the form of a share of any capital appreciation in the asset purchased with the loan. Repayment typically occurs at the end of the loan term, or when the asset is sold, whichever happens first.
Linking back to our example of parents loaning funds to their child, they might not require any repayments during the term of the loan but may seek to enforce their return if their child is subject to a third-party claim and the asset has to be sold or transferred. Alternatively, they might decide to forgive the loan on their death.
How can the equity loan be secured?
Like any loan agreement, security provisions can be included in the terms of an equity loan.
In the scenario above, if the parents are concerned about a third-party claim against their child (for example, a relationship breakdown leading to a property settlement for family law purposes, or a creditor demanding payment in a business venture gone wrong) then the equity loan agreement can include provision for the parents to secure their interest in the loaned amount.
The options available to them are:
- Registered Mortgage: This is the most secure option as it involves recording the interest directly on the property title. With a registered mortgage, the owner cannot deal with the property without the lender’s consent and the lender is able to enforce their interest if needed. However, if there is another lender involved (like a bank), registering a mortgage, even as a second mortgage, usually requires discussions with and consent from the other lender. Registering a mortgage to secure a loan interest is the ‘gold standard’ in our view.
- Caveat: If the lender prefers not to register a mortgage but still wants to limit the ability of the borrower to deal with the asset, a caveat is worth considering. Registering a caveat over property prevents anyone from dealing with the property without the caveator’s consent. Lenders should keep in mind that caveats don’t grant the same enforcement options as mortgages, such as taking possession or selling the property. The lender will also need to be careful to ensure the loan document records the lender’s caveatable interest appropriately.
- Unregistered Mortgage: While it’s possible for the lender to include the right to register a mortgage in the loan agreement without actually registering it, this option is less robust when it comes to enforcement, especially in family law situations. We recommend that lenders seek legal advice if they are considering this option.
- Security interest on the PPSR: If the asset being financed is personal property (including shares or business assets), then the lender may consider taking a security interest over the asset and registering that interest on the Personal Property Securities Register (PPSR). This gives third parties notice of the lender’s security over the asset and priority over other creditors and comes with its own regime for enforcement. For this kind of security registration to be effective, it must be registered appropriately. We strongly recommend obtaining professional advice and assistance when registering any security interest on the PPSR.
As with any kind of loan, a lender under an equity loan agreement needs to seek appropriate legal advice about the security provisions included in the document to ensure that the terms of the equity loan agreement put them in a strong position, should the loan arrangement ever come under scrutiny.
An equity loan is a great option for a lender who is willing to forego ongoing repayments in exchange for a bigger slice of the pie later on. We have assisted several families and business owners implement this strategy and we would be pleased to do the same for you. If you want our advice or assistance with documenting an equity loan, please call us on 1300 654 590 or email us at email@example.com.
The information contained in this post is current at the date of editing – 14 September 2023.