Selecting an appropriate interest rate is critical to creating a successful personal loan. If you select a rate that is too low, the lender won’t earn an appropriate return on his investment given the risk and the IRS may even classify the loan as a gift. Select an interest rate that is too high and it might set the borrower up to fail. Below are a couple of key issues you should review when determining the interest rate for your loan:
Find an Appropriate Benchmark Rate
The best way to begin determining an appropriate interest rate is to look at a benchmark. You can review average LoanBack loan rates by loan type and average industry rates from Bankrate.com on our Key Lending Rates page.
In order to determine the interest rate you should use, find the rate for the compatible benchmark and then adjust the rate up or down depending on the level of risk associated with your loan.
If your loan is secured with collateral you might be able to give the borrower a discount on the interest rate since there is a greater probability that you can recover your principal in the event of a default. Typically the lender will ask that any assets purchased using the loan be used as the loan’s collateral (e.g. property deed, or auto title). Even if the loan will not be used to purchase assets that can be used as collateral, the lender can ask the borrower to offer up other valuable assets.
Determining the risk on your loan can be an intimidating process, but using simple common sense can help you figure out where your loan falls on the general risk spectrum. If your loan is unsecured you should look at the borrower’s credit history and credit score to help determine your risk. If you are lending money to purchase real estate you should review the property’s likelihood to retain its value or appreciate over the life of the loan. If you are lending money for a small business, ask yourself how confident you are in the business plan and the ability of the entrepreneurs. Asking the borrower to find a person with better credit to cosign the loan can also help mitigate the underlying risk.
Usury is a fancy word for an “excessive” or “illegal” interest rate. Usury laws vary from state to state and can be confusing for the average person to understand. If you are interested in learning more about the usury laws in your state check out this summary of Usury Laws by State. While we do our best to keep our usury information accurate and up-to-date, its important that you check with a local attorney or accountant if you have any questions about the interest rate on your loan.
Applicable Federal Rate (AFR)
The IRS will also be interested in the interest rate you set for your personal loan. If your interest rate is too low, the IRS may classify the loan as a taxable gift. For more on the AFR, check out our article on the Tax Implications of Personal Loans and Current AFR Rates.