Ask Dr. Don By Don Taylor, Ph.D., CFA • Bankrate.com

Lending money to a friend

Dear Dr. Don,
What do you think is a fair rate to charge for a loan to a friend? Also, where do I get a template for a loan agreement? I know that a personal loan from a bank is between 12 percent and 17 percent.
Thanks,
Mun Moneylender

Dear Mun,
The IRS establishes an applicable federal rate for loans. If you charge less than this rate, the forgone interest is a gift to your friend. There are some exceptions for gift loans between individuals, as explained in this IRS publication and partially presented below:

"For gift loans between individuals, forgone interest treated as transferred back to the lender is limited to the borrower's net investment income for the year. This limit applies if the outstanding loans between the lender and borrower total $100,000 or less. If the borrower's net investment income is $1,000 or less, it is treated as zero. This limit does not apply to a loan if the avoidance of any federal tax is one of the main purposes of the interest arrangement."

Now that we've discussed the gift issue of giving your friend a below-market interest rate, ask yourself what you want out of the loan. Are you doing this to be a friend or to make money?

If your friend's credit isn't good enough to get a personal loan from a financial institution, then you're taking on a risk that a professional lender wouldn't. From a risk-based perspective you'd want at least the going rate for a personal loan in your market. You can find the interest rate on personal loans in your region using Bankrate's personal loan search feature.

Another way to look at this is to figure the opportunity cost of your friend tying up your money. If you would normally have the money invested in a five-year CD, charging your friend the five-year CD rate replaces that investment opportunity.

My best suggestion is to make it an amortized loan where the contractual monthly payments include a principal and interest component. Loaning money to a friend on an interest-only basis lets him hold on to the principal until the note is due. That increases your risk. Use Bankrate's loan calculator to come up with the loan payment.

I didn't find a free loan agreement form on the Internet, but you should be able to put the terms to paper and get a signed, notarized agreement that would stand up to scrutiny in court. Alternately, the 'Lectric Law Library sells loan forms online at reasonable prices.

-- Posted: Nov. 11, 2002