Pick An Interest Rate

The interest rate is a percentage of the principal the borrower pays to the lender (in addition to principal) for the use of the lender's money. With private lending, the main task when choosing an interest rate is for the lender and borrower to agree on the rate. The decision is usually best made after considering the following factors.

Acknowledge the lender's opportunity cost. The money loaned to the borrower would most likely be earning if invested elsewhere (i.e. a savings account or CD). Consider that alternative and pick a rate that the lender feels is fair given alternative uses of the money.

Acknowledge the borrower's alternatives. Chances are, the borrower is seeking a private loan because credit from traditional sources, like a bank or credit card, is unaffordable. Determine what the going rate might be for the amount needed, and anything less should be considered "a good deal" for the borrower.

Look up the applicable federal rate (AFR). If the loan is less than $10,000, you can set pretty much any rate you can agree to, and many folks charge no interest at all.

However, if the loan is for over $10,000, private lenders should consider the Applicable Federal Rate (AFR) as the minimum. The AFR is an interest rate set by the IRS for loans between individuals. It's particularly important to meet or exceed the AFR with larger loans because otherwise the IRS will consider imputed interest a gift, and the lender may risk incurring a gift tax liability. (See What the IRS cares about ). The AFR changes monthly; you can look up this month's rate here or learn more at the IRS website.

Respect usury laws in your state. Usury laws were originally instituted to protect people from unreasonably high "predatory" interest charges, and most states have instituted specific limits on the maximum interest rates that lenders can charge. In general an interest rate up to 18% is widely acceptable. Different states have different usury laws, and if the state laws are violated, the promissory note may be unenforceable if brought to court. If you have concerns that your rate may be usurious, contact the state department in your state, or an attorney.

Learn more about usury limits

In closing, the lender and borrower need to balance these factors to agree on a rate that each feels is fair and which, ultimately, the borrower can afford to repay. Often in private lending, the rate can be a win-win, better than the borrower's alternative credit sources, and better than the lender's alternative short-term financial investments. And sometimes, the parties agree that a 0% rate is the best choice.

Please note: The material presented above is information, not advice. For financial or legal advice, and for the rules and regulations that apply to your situation, please contact your attorney or accountant.