Setting Interest Rate for Personal Loan

[scfr]

DH & I are considering making a short-term loan to a long-time acquaintance so that he can start up his own business. The one question that remains is how to set the interest rate.

Has anyone here done something similar, either as a lender or as a borrower? If so, how did you set the interest rate?

[disneysteve]

I believe there are actually some tax laws concerning this. If you set the rate too low, there can be tax consequences (if they get caught) so I'd suggest looking into that or consulting your accountant if you have one.

And obviously, you and your husband need to be totally on the same page about the fact that this is a GIFT, not a loan. You have to be 100% okay with never seeing that money again. Also the fact that it will poison your relationship with that person.

[scfr]

I believe there are actually some tax laws concerning this. If you set the rate too low, there can be tax consequences (if they get caught) so I'd suggest looking into that or consulting your accountant if you have one.

Good point, and yes, I have already researched and am aware of the AFRs (prescribed by IRS) and the rate charged will definitely be above that.

[disneysteve]

Good point, and yes, I have already researched and am aware of the AFRs (prescribed by IRS) and the rate charged will definitely be above that.

Then the question really is what your goal is. Are you trying to help him out and lend him money at a better rate than he can get commercially? If so, set the rate somewhere between the going rate and the required minimum.

If he just can't qualify for traditional financing, you can charge him market rate since that's better than what he can get anywhere else.

Make it all legit with a loan agreement and documented repayment plan, penalties for late payments, etc.

[james.hendrickson]

Scfr,

Good call on getting the IRS minimums - you don't want to create tax problems for the person who is borrowing the money.

Here is one way to approach it:

1) Set the rates based on the legal minimum and maximum.

The minimum rate as the minimum amount that the IRS will let you charge.

The maximum rate could be the maximum rate your state will allow you to charge.

That will give you the upper and lower limits of what you can charge. Conforming to your best interpretation of what Federal and state law allows you to charge is probably safe ground.

2) Calibrate the rate to what your risk.

For example if you think the person you are lending to is higher risk, you might set the rate towards the higher end of the range to compensate you for taking the additional risk.

3) Factor in inflation. Two things here would be the length of the loan and inflation. If the loan is a longer term and you anticipate above average inflation, then you might want to set the rate towards the higher end of the limit to ensure that your effective loan rate isn't eaten away by inflation.

Finally, I agree with Disneysteve, you really need a contract.

My wife lend $5,000 to a friend several years ago, he has not repaid her. They didn't have a contract and she's kicking herself a bit now. So, best not to learn this hard way - get a contract and get a repayment schedule down on paper.

[disneysteve]

My wife lend $5,000 to a friend several years ago, he has not repaid her. They didn't have a contract and she's kicking herself a bit now. So, best not to learn this hard way - get a contract and get a repayment schedule down on paper.

All of that said, understand that a loan agreement doesn't make it any more likely that you will ever see the money unless you are willing to sue your friend and they have the means to pay you if you win. And of course they will no longer be your friend by that point.

The only real purpose of the loan agreement is to hopefully make the borrower treat it more seriously than just a friend helping you out.

[james.hendrickson]

All of that said, understand that a loan agreement doesn't make it any more likely that you will ever see the money unless you are willing to sue your friend and they have the means to pay you if you win. And of course they will no longer be your friend by that point.

The only real purpose of the loan agreement is to hopefully make the borrower treat it more seriously than just a friend helping you out.

Exactly - it clarifies and sets the tone.

[scfr]

Scfr,

Good call on getting the IRS minimums - you don't want to create tax problems for the person who is borrowing the money.

Here is one way to approach it:

1) Set the rates based on the legal minimum and maximum.

The minimum rate as the minimum amount that the IRS will let you charge.

The maximum rate could be the maximum rate your state will allow you to charge.

That will give you the upper and lower limits of what you can charge. Conforming to your best interpretation of what Federal and state law allows you to charge is probably safe ground.

2) Calibrate the rate to what your risk.

For example if you think the person you are lending to is higher risk, you might set the rate towards the higher end of the range to compensate you for taking the additional risk.

3) Factor in inflation. Two things here would be the length of the loan and inflation. If the loan is a longer term and you anticipate above average inflation, then you might want to set the rate towards the higher end of the limit to ensure that your effective loan rate isn't eaten away by inflation.

Thanks for sharing your thoughts on setting the interest rate!

As far as other things mentioned on this thread, in my original post I included the statement "The one question that remains is how to set the interest rate." quite deliberately and specifically (or so I thought). All other aspects of the loan have been researched, analyzed, assessed, discussed, covered. Really I'm just interested in suggestions on setting the interest rate.

[disneysteve]

Really I'm just interested in suggestions on setting the interest rate.

Basically, that's up to you as long as you are within the legal range. It's partly based on your assessment of risk and partly based on how nice you want to be.

[Gailete]

DH & I are considering making a short-term loan to a long-time acquaintance so that he can start up his own business. The one question that remains is how to set the interest rate.

Has anyone here done something similar, either as a lender or as a borrower? If so, how did you set the interest rate?

I loaned my son the money for buying his first car. I kept the interest rate low and had the payment plan tacked to the fridge so we both knew what was owed. I think I charged him enough to cover the lose of what I earned in interest during that period. But loaning $1500 to a son is a whole different thing than loaning to a friend to start a business.