August 25, 2015

Loan with a Purpose




Many smaller investors are willing to offer loans to borrowers who do not want a loan from a traditional financial institution.  The slightly higher costs of the loan are often worth it, considering borrowers will avoid the many hassles and daunting requirements of traditional lenders.


With a willing lender and a willing borrower, what could possibly go wrong?  The short answer is that a lot can go wrong.  Besides the obvious, such as defaulting on the loan, there is one trap for the unwary lender that should not be ignored: the loan’s purpose.


Why does the purpose of the loan matter?  Because when a default does occur on a loan, the stated purpose of the loan may have a dramatic effect on the lender.  There are many varieties and types of loans, but they all fit into one of two categories: business or personal.


Let us say that as a smaller investor, you want to make loans of a business nature.  The borrower comes to you and says that the loan is for construction for a business.  To most it would seem to be a no brainer: it’s a business loan.  If it is a business loan, then all of the documents need to state the business loan as the purpose.


Why is it important to state the purpose of the loan in the loan documents?  Because if the purpose of the loan is not stated in the documents, and the loan defaults, the lender could be found to be a usurious lender in the state of Washington.  The Washington Supreme Court recently issued an unpublished opinion in which a small investor was found to have charged a usurious rate of interest because it did not state the loan’s purpose as business within the loan documents.  It was therefore a personal loan.  Personal loans have far more controls regarding interest rates than do business loans, and the lender was substantially financially penalized for charging too high of an interest rate on what was deemed as a personal loan.  No Oregon case has directly confronted this issue.  A perusal of cases would indicate a potentially similar result in Oregon if brought through the courts.


The test for whether a loan is a business or personal loan is seen from the eyes of the borrower, not the lender.  If the loan documents do not say anything, then the loan purpose is determined by the borrower’s subjective statements of the purpose.  The takeaway?  The borrower and lender need to agree to the purpose of the loan and put it in writing in the contract. 


It is not hard to make a loan business instead of personal in nature, if in fact it is for business.  A clause simply needs to be inserted into the loan documents that states the business purpose of the loan.  The clause just needs to say that the borrower and lender agree that the loan’s purpose is for business with a brief mention about the ultimate use of the loan proceeds.  If the lender requires a personal guarantee for a loan made to a business, then similar language also needs to be included in the personal guarantee.  It is important to note that placing a statement of business purpose for a loan in the recitals of the loan document, if there is a recitals portion, may not work for creating a business purpose in the loan documents, unless the recitals become incorporated into the operative portion of the contract.


Sometimes simple things get overlooked.  If you are offering small loans, make sure you do not overlook the importance of stating the purpose of a business loan in the loan documents and any guarantees.  Without paying attention to the addition of the “business purpose” clause to each of the loan documents, a small investor making loans could end up on the wrong end of a court decision.

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