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Family lending

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Benel-Lagua-125

FINEX Folio

Seventeen years ago, I wrote about the concept of “Family Loans”, inspired by Robert Merton and Zvi Bodie in their innovative text Finance. Whenever I raise the issue in my Finance classes, I realize the concept can benefit today’s millennials. Allow me to revisit the same topic.

Suppose you are 30 years old, just got married, and want to buy a house for P1 million. Your bank is willing to grant you a mortgage loan for P800,000 or 80% of the purchase price of the house at an effective interest rate of 12% per annum, but you need a 20% down payment of P200,000.

On the other hand, your elder sister has some savings placed in time certificates of deposit and she can get only about 4% per annum if the deposit is rolled over.

With a little creativity and some straight thinking, these two circumstances can be turned into a family loan and both parties can benefit from the deal.

The elder sister can lend directly to you and the intermediary is eliminated. This means that you get the mortgage without the additional costs such as taxes and application fees. The loan will take less time to process, and the interest rate should be lower.

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Simultaneously, your elder sister can increase her own return. Rather than the 4% per annum time deposit rate which is actually even 20% less because of withholding tax, she can charge a higher amount, say 6% per annum, and still offer you a bargain. She can even finance part of your down payment so that you get easier terms.

This decision is possible because as Merton-Bodie discuss, the financial system provides price information that helps coordinate decentralized decision making in the economy. Knowledge of market interest rates should allow transactions within families in a manner that will benefit all members.

Family loans are exemplary ways of showing that in a functional financial system, we will all be better off. Competition in the financial system should reduce the cost of intermediation. And one such way is by eliminating it altogether as in family loans.

However, family loans rarely happen especially in the Philippine setting. I’ve been surveying my MBA and undergraduate students in Finance on whether they practice this. Rare is the situation where a positive reply is given. When family loans are accommodated they are generally on a pay when able basis and are tempered to a minimum. No interest is charged and the lender loses on the time value of money alone. Finally, the lender will accommodate just enough in anticipation of non-repayment.

Because of the lack of appreciation of the benefits of this system among kin, siblings and close relatives are considered poor credit risk, despite all the love and familiarity we can factor in the relationship. Parents who lend to children, sisters to brothers, cousins, etc. find it difficult to collect from each other. They view it as a grant with option to collect. Add Filipino characteristics like hiya, utang-na-loob and pakikisama, and the family loan is doomed even before it starts.

We can all benefit from family loans. One might want to introduce a third-party arbiter, maybe a financial adviser, who should be independent, between the family borrowers and lenders. The transaction must be treated as an arm’s length business deal. The objective must be a win-win arrangement for the parties.

We belabor the need for family loans more especially if the proceeds are to be used for a business venture. Start-ups are rarely financed by formal financial institutions. And pricing is often high despite the low interest rate regime in the economy. New undertakings are often financed by the so-called 2Fs, friends and family. While the more endowed family member is usually ready to provide limited grants (or equity), funding can be increased under our family loan concept. And more new undertakings will be financed by the 2Fs if there is clear appreciation of the discipline and integrity needed by both borrower and lender. Otherwise, only the third F will show up for such accommodation — fools!

There are enough signals in the market place to make such transactions happen. All family members need to look at are market prices of similar assets to settle on the price of the transaction. And it can be mutually beneficial in comparison to deals with formal financial institutions. When accommodating requests of close family members, there may be a part given as largesse, but the real family loan should be well defined.

If only we can tap family loans in a big way, our economy will move forward faster. Imagine the pool of funds available from family members who work abroad. There is no Filipino without at least one relative in the US or elsewhere as an overseas worker. Surely, our relatives abroad mostly put their money in “safe” financial institutions. If family loans can only be made “safer” as it should be because of the drastic reduction in information asymmetry, the economy as a whole will be better off.

 

Benel D. Lagua was recently EVP and Chief Development Officer at the Development Bank of the Philippines. He is also a part-time lecturer at both Ateneo and DLSU. He is an active member of FINEX and is an advocate for innovations in SME Finance. Feedback and comments are welcome at

benellagua@alumni.ksg.harvard.edu

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