Fair interest rate on $2k personal loan to a friend

Question

A friend wanted to borrow $2,000 from me and he promised that he would pay it back in a month. I'm about to lend him the money. How much interest should I charge that would be fair? I am not expert on lending money, especially with this amount.

Answer 1

Shakespeare was pretty clear on this almost 500 years ago.

Neither a borrower nor a lender be, For loan oft loses both itself and friend...

There's a high probability (approximately 30-50% depending on how close you are to them) that your friend will borrow the money from you and simply not repay it. There's also the strong possibility that the process of collecting the money will result in the friendship being destroyed, rising to a practical certainty if you need to undertake any sort of legal action, plus you're potentially suing someone who has a history of not having anything worth taking.

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Charging interest isn't going to offset the risk of them stealing from you. What you need is collateral that's worth at least as much as the value of the loan.

"Hey Bill, I'm happy to lend you that money but you understand I need to cover myself in the amazingly unlikely case that you can't pay me back. The deed to your car should do it"

If they say no, then you have your answer. They were planning to dupe you.

Answer 2

"Fair" is not something that we are likely to be able to quantify. In the US right now (June 2024), banks would charge something like 36% annual interest on a credit card cash advance. That works out to ~3%/ month or $60 if your friend pays you back in a month. If your friend is coming to you because he has had issues with credit in the past, that gives you some compensation for the risk that your friend never pays you back. It probably doesn't give you enough compensation for that risk-- personal loans to friends are particularly likely to not be paid back because the lender allows the borrower to slide in the name of friendship.

But suggesting a credit card-like interest rate to a friend because of the risk that you aren't paid back on time (or at all) is tough for most people. Usually, one comes to a friend for a loan in the hopes that the friend will charge a much lower rate than a credit card. Your friend might find 12% (roughly the current rate for an unsecured personal loan from a bank to someone with exceptional credit) or 7% (roughly the rate of a mortgage loan secured by a home) to be "fair". If you charge less than 5.06% (the current IRS applicable federal rate (AFR)), you would technically owe taxes on the imputed interest even if you never received it (though no one is going to come after you for a few dollars of imputed interest income).

Unfortunately, it is very very likely that the rate that would be considered "fair" in terms of compensating you for the actual risk you are taking with your money is likely to be much higher than the rate that your friend would consider "fair" as a borrower. That's why the general advice when lending money to a friend (or relative) is to only lend money that you're OK never getting back. If you do get repaid, consider it a bonus.

Answer 3

Interest rates reflect the lender's concern that they might not get the money back when promised (or at all).

They also reflect "opportunity cost" --the returns you would have gotten if the money had stayed in your bank account. If your money is earning interest/dividends/whatever, and you loan the money to the friend instead, you have to give up a chunk of those earnings. A case can be made that unless the friend gives you at least the same return on that money, you are giving them some part of the loan as a gift, since you will be worth less after it is paid off than if you hadn't made the loan. So even if you have perfect faith in their paying on time, this is one possible definition of "fair".

For me, that would mean charging the friend about 8% annually to cover the lost growth, plus a percentage reflecting how much I trust them, would be numerically fair. And if they don't like that offer they're welcome to borrow elsewhere.

But usually I don't give a flying about what's fair. I care about helping a friend and/or about not blowing up the friendship if something goes wrong. As a result, I either don't lend at all or lend only amounts that I would be willing to lose entirely, and either call the lost interest a gift or charge what I think they can afford (which is often the same thing).

When bailing out a relative, I charged 0.03% -- because anything less would not let us legally structure it as an in-family mortgage, and because they wouldn't have accepted the help unless I charged something rather than making it entirely a gift.

There's kind, there's reasonable, and there's "find another banker". As the lender, you need to decide where you want to be in that spectrum for this particular loan. There is no one right answer. But hopefully I've given you a few tools for thinking about what you want to do.

Answer 4

That's probably not the answer that you are looking for but my general rule of thumbs is:

A friend that I'm willing to loan to, I have no doubt that he will pay back and I wont even think of charging interest. Any other friend is more of a "friend"

The first type of friend won't loan money from me, so that deducts the Money U Loans to 0.

Answer 5

Loan have interest rates for two reasons: generate profit and to offset opportunity cost. Part of the calculation on whether it will generate a profit is the fact that if you do a large number of loans, some of them will fail (death and disasters happen even with the best of planning).

As you are making a single loan you can ignore the chance of failure.

So, a simple profit and a simple opportunity cost. Opportunity cost on 2k, with current interest at about ~5% that’s about $10. 50% more for profit, and it’s $15.

So, less than the price of a meal at a cheap restaurant.

Personally, I’d be greedy and have them buy me a meal and call that square, sounds better and is actually worth more.

Now, all of this is ignoring the real issue, what happens to your friendship when your friend doesn’t pay you back? Do you think it can survive and are you willing to risk that?

Answer 6

What is your relation to this friend?

That, more than financial mathematics, should inform your decision. The closer friends are, the more interactions with them in general are less formal and more of the "take some, give some" kind, where you don't keep tabs because over the years of a friendship, it evens out.

So, is this a friend where if you two went to lunch together, you would split the bill, or would you just pay because last time he did or something like that?

You should make that loan in the same spirit.

The second factor is: How much is $2k for you and can you spare it? If it means inconveniences or costs for you, then getting reimbursed for those is fair.

But between friends, IMHO either you are close enough that a few bucks of interest don't matter and he'll pay you back some other way (e.g. helping you the next time you need help with something) or if the friend is not close then keep money out of the friendship and don't loan at all.

Answer 7

Frame challenge.

If you "lend" money to friends or family, consider it as lost, with a very small chance that by pure luck they will pay you back.

If they ask you rather than a bank it's because the banks won't lend them the money, and banks have (a) better ways of determining whether someone is trustworthy enough and (b) often better ways to get their money back (or at least part of it) if they don't pay back (repossession). You don't have either.

If this is for some kind of business venture, then do not lend them the money, invest in the venture. The chances you see your money back are probably not much higher (that's why those investors are called "Friends, family and fools"), but at least if the business flourishes you can make quite a bit more, which may be worth the risk (though do not invest just because they are a friend, but because you have looked into their project and judged it at least somewhat viable).

If your friend is in dire straits, needing the cash just to keep afloat (to pay rent, to repay a loan or credit card bills...), then lending them money will not help them, it will just make a bigger hole in their finances. What will help them is education about better management of their budget.

If despite all this you still want to lend them money (remember, it's really a gift disguised as a loan), then in many places there's a maximum rate you can make them pay, beyond which the tax man will consider you are making money out of it, and will require you paying taxes on the interest received (or may even consider you are acting as a bank, which is often regulated). Or on the contrary there is a minimum interest rate, below which they consider it's a gift rather than a loan.

In the US the relevant rate is the Applicable Federal Rate (AFR) set by the IRS. You can read more about it here.

The loan should be documented in writing (in some countries it needs to be declared to the tax authorities or notarised), just to make sure it's not considered a git or a payment for services (income for the recipient) which would be taxed.

It's illusory to think such an agreement could be used to get your money back, unless you manage to get some form of guarantee/lien you can use, but that's probably a bit over the top for $2000 (and again, while a bank is used to handling those, you aren't).

Answer 8

he promised that he would pay it back in a month

The interest rate is inconsequential compared to the risk of never seeing the original $2,000 ever again. You're not a bank and high-risk, negative reward is the usual outcome.

Turn this "promise" into a binding contract with a payment schedule and potentially collateral.

If you value their friendship then you will not charge interest for such a short-term loan.

If the other person values your friendship then they will pay back the entire principle within a timely fashion.

The reality is that a person who actually needs $2,000 and thinks they can comfortably pay it back in a month is not on level ground. Do they actually have a plan for getting caught up within one month's time? At $15/hour, they would need to work 89 hours of overtime in a month to earn $2,000; that doesn't sound sustainable to me. A realistic repayment schedule is $300-500 per month.

As a friend, I would have said that $500 is all I can offer for now. In my mind, I'd write it off as a gift so I can sleep at night but would hold them accountable for repayment.

Answer 9

As noted by others, interest reflects the opportunity cost of investing/spending the money somewhere else. This applies to you but also to the LENDEE.

Why is this important? If you charge your friend 0% interest and loose payback terms, you may run into a scenario where your friend has no urgency to pay you back because the opportunity cost of paying you back is HIGHER than if they paid down other debt, or bought a new car, or a boat, etc.

So when I loan money to friends, charging interest is not about making money, but to create a bit of an incentive to get paid back in a timely manner. That interest rate IMO should be similar to the current bank mortgage interest rates. Often at the end of the loan I just forgive the interest charge when it's paid back on time.

Answer 10

If you give money as a loan to a friend, as a rule of thumb you will lose your money, or your friend, or both.

So either accept losing a friend by creating a contract that forces the friend to pay the money back, and being willing to force them. Or accept losing the money, which is fine if the friendship is worth more than the money.