Published on: 01 May, 2022
Updated: 16 November, 2022
Did you know that the interest rate on a loan you create is one of the most important loan terms you can set? 🤔 When someone you know—like a friend or family member—is borrowing money from you, they need to pay interest. Otherwise, you get stuck with the taxes.
Here’s the rundown on why interest rates matter and how much to charge when lending money.
What we’ll cover:
- Do you have to charge interest when lending money?
- Tax implications on loan interest rates
- How lending money can help loved ones with bad credit history
- Interest rate minimums and maximums when lending money
- Negotiating interest with a borrower
Is it necessary to charge an interest rate on loans with others?
You may be asking yourself, "Can I lend money to a friend and charge interest?" or "Is it illegal to lend money and charge interest?”. Well, the easy answer to those questions is yes - it is legal to lend money and charge interest, and in most cases, you should charge interest when lending money to someone you know. Failing to do so can result in tax penalties with the Internal Revenue Service (IRS), which can become costly. The IRS classifies some interest-free loans as gifts (see below for details), and applies a gift tax, which is more expensive than taxes on loan interest.
Pro Tip: In Uncle Sam’s true fashion, there’s an exception to this rule. The IRS does not require lenders to charge interest when the loan amount is less than $10,000 AND the borrower isn’t using the money to buy an income-producing property. This includes all outstanding loans between you and a borrower, so you can’t get around this with multiple loans.
Understanding tax implications on interest rates when lending money
Your taxes can get all fudged up 🍫 if you don’t charge interest (or the right interest) when lending money.
When you lend money to someone with low or no interest, the IRS may consider it a gift if you can’t prove the borrower paid you back. The IRS taxes loans and gifts differently. Here’s how:
- Gift tax: The IRS taxes the gifter. Any gifts above $15,000 (increased to $16,000 in 2022) get deducted from a taxpayer’s lifetime gift tax exemption. Once a taxpayer reaches their lifetime gift upper limit (currently $11.7 million, decreasing to $6 million in 2026), they must pay a 40% tax on all future gifts.
- Loan interest tax: The IRS taxes the lender, treating interest received on the loan as income. If you don’t charge interest (or don’t charge enough interest) but you can prove the borrower repaid the loan, the IRS will calculate the minimum interest rate for you and tax you based on that income. That’s right—even if you didn’t get the “income,” the IRS will still tax you for it. By charging interest (even the minimum rate), you’re protecting yourself from losing money on the loan through taxes.
How lending money can help a friend or family member with a bad credit score
Individuals can get personal loans through banks, credit unions, and online lenders—but those interest rates tend to be higher than loans from people you know. This is especially true when someone has a low credit score. For reference, FICO considers a bad credit score to be below 670. We know that disparities across racial and gender lines exist in credit report scoring, and it can tangibly hurt one’s ability to borrow.
According to Bankrate, people with a good credit score of 720–850 get an average loan interest rate of 10.3–12.5% from banks or online lenders.
Meanwhile, people with credit scores of 630–689 pay an average of 17.8–19.9%. That’s as high as some credit card interest rates, which are notoriously expensive.
Lending money to someone you know can help them get a lower interest rate than the rates that companies charge. Here’s a bit more on what interest rates on personal and family loans look like.
Smart Tip 💡: If your credit score has you stressed, you can automatically build credit with the bills you’re already paying by using StellarFi’s credit building tool to report your on-time payments to the three major US credit bureaus (Experian®, TransUnion®, and Equifax®). All with no deposit, no credit check, & no interest!
How much interest should I charge for lending money?
There is a minimum and maximum interest rate you can charge on private loans. Here are the details so you can determine a good interest rate for lending money:
What to know about minimum interest rates when lending money
The minimum interest rate that a lender can charge on a private loan is called the Applicable Federal Rate (AFR).
The AFR updates monthly based on economic factors. For example, AFRs in April 2022 are:
- Short-term loans: 1.26%
- Mid-term loans: 1.87%
- Long-term loans: 2.25%
What to know about maximum interest rates when lending money
Charging an exorbitantly high-interest rate on a loan makes it a usurious loan. Each US state has its own usury laws with maximum interest rates for private loans. For example, the maximum annual percentage rate in Nevada is 40%. In Vermont, the maximum is about 18% annually.
Look at your state’s usury laws about loan terms and refer to the maximum finance rate and fees.
How to negotiate an interest rate with a borrower
Lending money to someone requires a contract that satisfies both the lender and borrower. 🤝🏽A huge part of that contract is the interest rate.
When creating loan documents, the lender should propose an interest rate based on three considerations:
- The federal minimum interest rate (AFR) for personal loans
- Usury laws in the lender’s state of residence
- The borrower's monthly income and expenses flowing in and out of their bank account, or a general estimate of their ability to pay (you want the borrower to keep a good debt-to-income ratio)
Make sure the borrower knows that paying for interest is all a part of the cost of borrowing, but it shouldn’t drown them.
When lending money, set an interest rate that’s above the federal minimum and below your state’s maximum. This is a key factor in a larger set of repayment terms, and your family loan agreement will cover it all.
Charging the right interest rate when lending money keeps you from losing money on the loan. Now that’s a personal finance tip every lender should know. 🤯
Pigeon Loans 🐣 is an ideal solution for people lending money to friends and family. The platform keeps all the loan documentation, including interest rate, on file at all times—and sends payment reminders on your behalf. 🤙🏽 Start a personal loan with Pigeon Loans today.
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