Lending money to a friend or relative can be a smart financial decision for both sides if the loan is properly structured and formalized. From the borrowers perspective the personal loan is an excellent opportunity to find cheaper financing compared to a loan from a traditional lending institution or high-interest credit cards. The lender can also benefit from a higher return on their investment compared to a money market, CD or regular checking account, albeit with greater risk.
Since the global credit crunch began in 2008, the returns on traditional investment vehicles have plummeted. The S&P 500 fell by 37% in 2008 and home prices have fallen by more than 50% in some areas of the country. As the Federal Reserve continues to keep interest rates low to stimulate the economy, the interest paid on high-yield checking accounts and money market accounts has hovered in the 2% - 3% range. The falling price of real estate combined with the scarcity of traditional loans and low savings interest rates has created a unique and profitable arbitrage opportunity for personal lending.
Let’s assume that a young couple has been trying to buy their first home for years without success because of the housing bubble and their borderline credit. Real estate prices have finally fallen to the point where they are able to find the perfect starter home for $125,000. The couple is able to find a 30-year fixed rate mortgage at 7.00% assuming a down payment of 30% or $37,500. In addition to the down payment, the couple will also have to pay several thousand dollars in fees and closing costs.
The couple’s parents are retired and are searching for an investment that will yield more than the 2-4% on a 6-month CD. The parents can make a personal loan to the young couple on the same terms as the bank or give them a discount, saving the couple money on loan fees and interest. In return the parents receive an enhanced return compared to a regular bank account. The personal loan would be riskier than parking the money in an FDIC insured bank account, but the risk can be mitigated if the loan is secured by the home like a regular mortgage.
