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Should you lend money to a friend?

An IOU is not enough.

A common misconception among the general public is that some documentation, such as an IOU, is all you need in the decision to make a personal loan to someone else. Is it really that simple? Let’s find out.

#1: Have A Proper IOU

Should the borrower refuse to pay back your money, you would require documentation for the loan for be seen as valid in legal terms. Hence, it is essential to draw up the IOU properly, with all the necessary information.

Beyond the usual IOU template, necessary details to take note of include the date of loan, repayment date, guarantor (if any), identification numbers, interest payment terms, who is to bear the legal costs, collateral etc. IOUs should also be kept in mint condition, and avoid any ambiguity (unclear terms that can be up for multiple interpretations).

#2: Understand Recourse

Recourse here in the legal sense refers to the legal process in getting back your money. Unfortunately, it is not as simple as going down to a police station with your IOU and demanding they help to arrest the borrower.

Things to understand include where to go to make your claim, validity of IOU and so on. For example, depending on the amount that you owe, you need to make either a claim with the Small Claims Tribunal or a civil claim with the courts. In addition, IOUs have a typical shelf life of 6 years – meaning you need to start legal proceedings 6 years from the repayment date.

If the claim goes through and is approved by the court, enforcement is another layer of procedures that you need to be familiar with. From recourse to enforcement, the fees could add up (administration, lawyer fees etc.), making less economic sense to lay claim on smaller amounts (below $10,000). Really difficult borrowers may require you to hire a debt collection agency, which may end up taking a huge chunk of the final claimed amount. All these need to be considered BEFORE you make the loan.

#3: Consider Alternatives

While it may seem like a good idea to help a friend out and receive interest at the same time, such personal loans hardly seem to be a good deal to the lender. In a typical scenario – given the money was used to start a small business, and if the idea was good, there should be no lack of investors (ie. No need for personal loan).

From the interest angle, there are many choices in today’s financial markets that offer better deals for equivalent risk taken (such as high yield retail bonds or p2p lending) – unless the interest rate is skyhigh, which also signals extremely high risk of principal loss. Ultimately, the troublesome procedures in recourse and enforcement should also play a huge role in the decision process of making a personal loan a viable choice.

Read Also: Instalment Loans Vs Credit Line Vs Balance Transfer: Which Should You Use?

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