Friday, March 10, 2006

On charging interest

One of the more pressing questions people have when considering making a loan to someone they know is whether or not to charge interest, and if so how much. First I'll share some personal opinions on this topic and then share with you some cold, hard data on what real LoanBack users are actually doing.

I think charging interest on personal loans is a good idea for several reasons:

1) Lenders deserve to be compensated for the risk they're taking. After all, we all have plenty of alternatives for parking money. Hell, Emigrant Direct will give you 4.50% for almost no risk at all! With a loan -- like stocks, bonds and other investments -- there is risk of losing money. Lenders should require a return commensurate to the risk they are taking.

2) Successful personal lending starts with the borrower treating the loan as if it were from a bank. Since you are reading this, you already know that the best way to get borrowers to take the loan seriously is to draw up a Promissory Note. The next best thing is to charge interest. Doing so sets the tone of the relationship which should be one of friendly professionalism.

3) Avoid Tax implications. If you're lending more than $11,000 which is the maximum amount the IRS allows for individual "gifts", you should charge a minimum of 4.38% interest (the Applicable Federal Rate or AFR) so that the IRS won't consider the loan a "gift" and thus count against your gift limit. You can learn more about the AFR at the IRS website.

As for what rate is appropriate, I think it depends on the use of the loan and the situation. If the borrower is a good credit risk and wants to by a car, charge an interest rate a point or two below the market lending rate for auto loans. If the borrower is consolidating other debts and can't get credit, then charge a market rate or above-market rate. A great source of information on market lending rates is BankRate.com. If this monthly payment is too high, extend the term by a year and see what that does. One great benefit of personal loans is you can play with the variables of amount, interest rate and term to come up with the payment that meets the borrowers budget. Of course, there will be times when you don't think charging interest is appropriate. That's a judgement call that a lot of people decide to go with.

Enough of what I think. Let's look at what real-life LoanBack users are doing...

In February, over two-thirds of LoanBack users created interest-bearing loans. The average interest rate charged on these loans was about 8%.

It's interesting to note the effect of collateral on lending rates. Not surprisingly, LoanBack borrowers who put up some kind of "security" or collateral, got cheaper money than those who did not. The average interest rate for loans secured with collateral was 5.62% while the average rate for unsecured loans was 10.1%.

Note to borrowers: put up collateral when borrowing money from someone you know! You can clearly get a better interest rate if you do.

3 Comments:

At 1:48 PM, Anonymous Anonymous said...

Is there a legal limit to the amount of interest that can be charged on a personal loan?

 
At 2:37 PM, Blogger Hill said...

Each state has usuary laws which are intended to cap the interest rate on loans. It's obviously very difficult to enforce these laws, so it's not surprising that they are sometimes broken (i.e., loan sharking). Prosper.com has published a list of each state and its maximum legal lending rate. Hope this helps.

 
At 8:30 PM, Anonymous TJTombo said...

Is there a limit how much a credit card bank can raise its intrest rate in Colorado? From 14% to 31% over a six month period seems criminal.

 

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