A “lawsuit loan” is a loan made to a plaintiff to cover costs until a lawsuit is settled.

Imagine you are in an accident where it is clear that the other party is both insured and at fault. Settlements take months if not years to negotiate and sometimes you even need to sue your own insurance company to get paid. You might be both injured and out of work. And if your everyday expenses don’t sink your finances, legal expenses might.

You might seek a lawsuit loan in order to pay your bills and/or legal expenses and count on paying back the loan when you collect a judgement.

Lawsuit lenders use lawyers to vet cases for their likely payout. They usually loan less than 20 percent of that amount. And then they charge a very very high interest rate for the money. They even run funds to raise capital for payouts, paying a smaller percentage to investors than they collect from the plaintiff.

Are lawsuit loans a good idea for plaintiffs?

No. Anytime you can avoid taking a loan at 50% or even 100% interest you should avoid it.

The possible need to fund a lawsuit is another reason to have a healthy emergency fund. Funding your retirement accounts is important. But we also recommend saving and investing some of your retirement funding in a taxable account. There are many financial planning reasons you might need a large amount of taxable savings (buying a house, the gap years, etc.) and funding a lawsuit is yet another.

In that regard they are like reverse mortgages, the only option when you have not planned well.

Are lawsuit loans a good idea for trial lawyers?

Yes. When a desperate plaintiff approaches you with a case where the likely payout is large, and you would like to take the case, you want to be able to take the case. Perhaps you can take the case based on a contingency fee of 30%, but that may not cover your business expenses and leave the plaintiff little off of which to live.

Most clients are not going to have an emergency fund. Most households are living hand-to-mouth. You want to have an easy answer where you can focus on the case (your area of expertise) and not the client’s household budget (not your area of expertise). Sending the client to get a lawsuit loan is an easy answer. Running your own lawsuit loan is even more lucrative. You can get money from investors and make money, not only from the contingency fee, but also from the loan transaction.

Are lawsuit loans a good idea for investors?

Not in my opinion.

They violate too many of the principles I believe make for good stewardship of your resources. If you just subject the idea of a lawsuit loan to the “Ten Questions to Ask a Financial Advisor” they do not fare well on many of them, but especially:

3. Is the daily price of everything you invest in listed in the Wall Street Journal? No. There is no way of knowing what your loan is worth. It is an illiquid investment and most of the time investors undervalue liquidity.

5. Could you teach me to implement your investment strategy and let me do it on my own? No. It is a judgement call by a lawyer which investments are worth making a loan. They have more risk than the stock market. And they are certainly wrapped in large fees as well.

6. After selecting your investment approach, could I change my mind at any time, immediately recoup everything left of my investment and have no financial hooks to keep me from dropping your approach? No. Once you have made the loan you have no way to back out. You have to wait for a judgement to be received in order to get any of your money back.

9. Is the fee I pay you the only compensation you receive? No. The fees associated with lawsuit loans are hidden within the funding structure.

I understand the good work that lawsuit loans are doing. They are allowing plaintiffs to continue to live while they are pursuing a fair settlement in court. If they are charging 1/2 percent compounded monthly (6.2% annualized) then they are probably providing a fair service for a 20% loan against a very likely payout. But at those rates of return, why give up the liquidity? And that is, of course, why the charges are often much higher.

On the other hand, if they are charging a 30% or 50% annualized charge to the client while paying the investor a 20% to 40% return, then I think the fund is being run to the detriment of society.

You need to know the value of the service being provided in order to know the return you should expect. And perhaps the most important principle for safeguarding your money is “Safeguard #2: Walk Away from ‘Too Good to Be True’“. Put another way, in stewarding your money you should avoid greed, fear, and pride. Safeguard #2 is another way of saying, “Avoid greed.” This type of loan should not pay 30%. And if it is paying 30% then there might be something wrong with the exchange. Perhaps you are not being told all of the risks. Perhaps the plaintiff is being misled and preyed upon.

As the New York Times reports in “Lawsuit Loans Add New Risk for the Injured “:

Lawsuit lenders do not advertise prices; they advertise convenience. They send letters to people who file suits, and run ads on daytime and late-night television, emphasizing that money is available quickly and easily.

When David Kert, a personal-injury lawyer, took a job in 2007 screening applicants for the lender Whitehaven Plaintiff Funding in New York City, he said he was told not to mention the cost of the loans unless asked directly.

Mr. Kert spent the next year answering 50 to 60 calls each workday from plaintiffs and their lawyers. He said many of those people ended up taking loans from Whitehaven without ever asking the price — as high as 99 percent of the loan amount in the first year.

“I’m sorry I spent any time there,” Mr. Kert said recently.

And that is perhaps the best reason not to invest in lawsuit loans. If  the lawsuit loan fund manager is not going to act honestly and with integrity, do you really want to be involved in ripping people off by misleading them and preying on their desire for fast money?

Photo used here under Flickr Creative Commons.