Today, a guest blog from my colleague, Eric Hartnett.
We all have had friends or relatives who have been short on finances and asked you for a loan. A private loan helps avoid the formal process of going through a bank or private money lender.
We understand where that friend or relative is coming from and want to help out because we rationalize that we have known them forever and that is what friends do for each other. Unfortunately, this rationalization can put the us into quite a predicament.
A standard hypothetical for this situation is that your cousin asks you if you could spot him $20,000.00 to fix up his house so that he can sell it. He tells you that he will pay you back in a couple months, if not sooner. You agree to help your cousin out and your cousin buys you a beer for being there for him. As you might guess, the house sells, he moves away, and tells you he is still getting situated in Alaska and that he will get the money to you soon. Obviously, there are millions of scenarios that keep someone from paying back on a personal loan. The reasons for non-payment sound reasonable and you do not take any action to make your cousin pay back the loan. Eventually, you have not seen your $20,000.00 for a couple years and decide that your cousin really needs to make good on his word. How do collect on the personal loan?
Presuming that informal methods, such as phone calls and letter writing, do not work, you will need to put the legal system to work for you and take your cousin to court. However, the legal system’s ability to help you is contingent upon how you reached the personal loan agreement with your friend/relative.
Personal loan agreements tend to be made in one of three ways. The first way is the oral promise/IOU. Your friend asks, you say sure and cut him a check. The second way is the handwritten note on a napkin. This is where a friend asking you for the money, but you want some form of writing to commemorate the deal even though you are sure your friend is good for it. The third way is a formal agreement that is signed by both you and your friend.
How does the method of your agreement affect your ability to collect via the court?
In the oral promise scenario, you face a couple of legal problems. The first is that the statute of limitations for an oral contract is only two(2) years. This means that if your friend was supposed to pay you back on a certain date and two years have gone by since that date, you are precluded from taking him to court to collect. The second is that with an oral contract you have to deal with he said/she said arguments. If you are currently in an agreement like this, we strongly suggest memorializing your agreement in writing. This has the benefit is extending out your statute of limitations period. If your friend or relative will not agree to that, then see if you can get a very small payment from them, such as $100. This small installment could also extend your statute of limitations.
In the handwritten note on a napkin scenario, there are also legal issues. If the napkin is not signed by your friend, then you will have the validity of the contract questioned. The sheer lack of formality combined with the lack of execution will probably make the court weary of enforcing the alleged agreement, especially if the court is presented with contradicting evidence from your friend. However, if the court finds that the napkin was a written contract, your statute of limitations becomes four (4) years, instead of two (2) years. Thus, the napkin method is good because there is at least some documentation of the agreement, but is somewhat frowned upon because of the lack of formality and the potential difficulties of having to prove an oral or implied-in-fact contract. Additionally, all material terms must be there, date, name of the parties, amount of the loan, repayment terms, etc.
In the formal agreement scenario, there is usually one problem. That problem is convenience. If your friend really needs the money he will take the time to review a short agreement with you and sign it. Please note that while this most likely creates a solid contract between the two of you, it does not secure your loan.
What is the best way to insure you will see your money again? The answer is that you utilize the formal agreement option, but then you secure the loan as well. You secure the loan by having your friend sign a promissory note and executing deed of trust that you record against his house. That way, you get paid at close of escrow, assuming there is enough equity to satisfy all the debt against the house.
Remember that the only guaranteed way to make sure you have the $20,000.00 in your bank account is to not make the loan. However, if you document the loan and then secure it, you have greatly increased your odds of collection.