What would be a recommended interest rate for an unsecured loan to individuals with mediocre credit rating and income close to expenses?

Question

I have a friend whose new wife is paying an absurdly high interest rate on her auto loan. They've asked if I was willing to loan them money at a more reasonable rate to pay off that loan and have them pay me back instead. I'm fully aware that loaning money to friends is usually a terrible idea and I'd be an idiot to consider it; sadly, I am an idiot.

Still, I'm trying to do things as safely for myself as I can given my aforementioned questionable IQ. I'm planning to offer a starter loan, a relatively small loan just to see if they can stay consistent to paying off that loan before agreeing to a larger one. I'm also going to insist on a predefined monthly payment and that they set up an automated bill pay so neither of us needs to remember each month for them to transfer the money, and basically see if they can make consistent payments each month.

Neither woman has great credit rating, the new wife's is particularly bad, though mostly due to her youth, with my friend's rating being better but nothing great - sorry I don't know the exact numbers, but I know they have been declined loans when trying to refinance the auto loan so clearly not a great rating. I know their income is barely covering their expenses now, though some of this is due to extra costs they could easily cut if they chose - though even after they asked me to review their finances and I pointed this out, they have failed to cut out those costs. Convincing people to use money wisely is usually a doomed endeavor. They are also planning to have a baby in a year or so, maybe a little longer depending on how long it will take to conceive, which will obviously add to their total expenses.

I do believe they have every intent to repay a loan I give them, but obviously they would still be considered a somewhat high risk loan given their financial situation. I need to figure out what interest rate would be reasonable to charge them. I already know what my opportunity cost for the loan is, my question is how much should I add on top of that base opportunity cost to cover the risk inherent in such a loan. I'm asking specifically what the recommended amount would be if this were a business loan, mostly ignoring the friendship angle for now. I'll decide if I want to give more favorable terms than that to them after I know what would be considered a recommended rate given their situation. I'm not looking to profit, only to break even, but 'breaking even' has to factor in the potential risk inherent in the loan.

I don't yet know how long they will have to pay off the loan, we are scheduled to have a discussion later this week when I'll have to figure out what monthly payment they are willing to make - I personally think it would be in their best interest, and allow me to feel more comfortable with a larger loan after this, if I were to push them to commit to a high monthly payment on the first loan to help get their loans payed off before they have another child. I suspect they will be resistant to such a suggestion though. As such, I might need a recommendation for how to adjust interest rate based off what we decide for a monthly payment and thus length of time until loan is payed off.

Edit:

In case anyone is interested, this whole question is moot. I ultimately calculated the lowest possible rate I could offer them for an unsecured loan, even with very favorable terms, is worse then they could get from a bank with a secured loan. Ironically, my very high allowance for risk due to my financial situation means I can invest in higher risk higher expected ROI situations that make my opportunity cost too high.

I couldn't realistically offer a secured loan to them, because there is no way I'd actually be able to bring myself to reposess their car even if I did have a legal right to do so; and besides which I want higher risk/ROI investments then that. So turns out their best bet is to get a secured loan from someone who is actually willing to collect on their loan if necessary, but who can offer an interest rate appropriate to the lower risk such a loan implies. Of course if I was really wanting to help them I could cosign the loan to offer them a noticeable lower rate, which would again bring me back to "I'm an idiot if I do this" territory ;)

Answer 1

You're not a bank, so don't try to think like one. Banks base their interest rate off of the average risk of default for similar borrowers based on carrying multiple loans to spread the risk. In your case, you have one loan that will either default or it won't. If it doesn't, then the interest rate is not a big deal. If it does, then the interest rate is completely irrelevant.

It's admirable that you want to help a friend, but I would approach it as a gift with the opportunity for them to pay you back if they can. The last thing I would want in a friendship is resentment over having to pay a bill, or choosing between paying you back and paying a utility bill. Base the payment on what they can afford, see how long it will take to pay you back without interest, then maybe add on a few more payments if you want to earn some interest.

So some guidelines I would keep in mind:

• Only do it if you could survive if they never pay you back. If you can't live without it then you can't afford to loan it.
• Make sure that you are not enabling other irresponsible bad behavior - are there parts of their lifestyle that could/should be cut given their situation?
• Could they just get a cheaper car instead of borrowing to buy this one?
• Do they have other family that could help out as well?

You might also consider getting something in writing at least stating how much was loaned, how long they have to pay it back, etc. Just so they don't sell the car and decide not to pay you back. You could go as far as filing a lien on the car so they can't sell the car without your permission, but it may not be worth the hassle.

That's just some guidelines I use to help people in a responsible way.

EDIT:

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I am intentionally ignoring any tax/legal considerations; just some basic guidelines on loaning/giving money to friends and family. Certainly you should follow applicable laws and pay applicable taxes on any income.

Answer 2

AFR

Depending on the exact relation between you and the borrower, you may need to set the rate to at least the Applicable Federal Rate, or suffer a possible tax liability. There are different rates based on the loan period. Current (Q4 2022) rates are around 2% +/- 0.25%.

Answer 3

From the comments, you're expecting 10% ROI on your current investments.

Someone suggested a 5% loan is a mutually beneficial business arrangement, but it's not; with that assumption, any money loaned at a lower interest rate than 10% is not mutually beneficial, even if payback is guaranteed.

Let's say your proposed loan is $10,000 over 5 years, 5% interest, and guaranteed to be paid back. Simple napkin math:

$10000 * 1.10^5 - $10000 * 1.05^5 = a gift worth just over $3300.

If they don't pay you back, it's a bigger gift that's likely to come with a free loss of friendship.

If you can afford a $3300 gift, give the $3300 gift, no need to worry about repayment. It might be possible that the friend can get a better interest rate with a larger down payment - it's less risk for the bank when they already have a chunk of the value of the vehicle up front in the form of collateral. Alternatively, if they're able to apply $3300 today to the principal on the loan without penalty it's likely to save them an additional $2000 or so over the life of a loan like I've described.

Answer 4

Personal judgement call based on how much you want to help them, what you consider the risk is, how upset you would be if it isn't paid back, what returns you think you would get if the money was invested elsewhere...

For large amounts you may want to look up "in-family mortgages". At the time I issued one I had to charge at least 0.3% interest to make the interest tax-deductable for the borrower. If I hadn't trusted the borrower completely, would have been upset if the loan was never paid back, or was worried about it's effects on my own finances I'd have charged "market rate of return", on the order of 8%. If I was making the loan reluctantly but still wanted to give them something better than obscene credit-card rates I would have gone higher.

Only you know what inconvenience this will be to you and what that inconvenience is worth. Pick a number that you will be comfortable with no matter what happens.

Answer 5

I have a friend

(...)

I need to figure out what interest rate would be reasonable to charge them.

0.0%¹.

It is not reasonable to ask money for helping a friend.

You wouldn't look up taxi fees if you gave your friend a ride to the hospital.

You wouldn't look up local restaurant and hotel fees if your friend were eating and staying at your place.

Asking them to pay in either case would be a great way to destroy a friendship.

At most you might ask them if they could contribute to actual expenses you make, but even that you would only do if you really needed to. If you're broke but helping a friend move, it's reasonable to ask them to pay for fuel/charge (but you wouldn't bill them for your time). That's not what's happening here. If you're lending out money to them, it means you're not broke.

Interest is profit on a loan, so asking interest when lending out money is similar to billing a friend if they eat or sleep at your place or when you're giving them a ride. You are OK with helping your friend, but only if you make a profit?

Interest is trickle-up economics. It is a way to transfer money from poor people to rich people, in which the poorest 80% of the population are net payers and the top 20% are net earners (the cohort is probably even smaller than the top 20%; moderately rich people tend to have expensive mortgages and thus transfer money to even richer people). Charging interest to your friend implies you are hoping to get richer by helping your friend. That's usury and not what friends do.

It also doesn't make sense from a risk reduction perspective. The more your friend needs to pay back, the higher the risk they can't, so charging interest increases the risk of not getting back your money. This might be different if you have 1000 friends and you would default if too many of them don't pay you back, but for a single case, the risk reduction argument doesn't work.

You can charge interest to your friend, but they won't be your friend anymore if you do. See also Stig Hemmers comment.

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¹For large loans, in some legislations, the recipient may have to pay gift tax if they get a loan at 0% and are essentially gifted the interest they would pay on an ordinary loan. If you loan out a lot of money, check the law in both locales to see what might apply.

Answer 6

Other answers have discussed the interest rate and "But really, don't loan to friends. If you insist, think of it as a gift that might be paid back." aspects of your question.

However, they ignore part of your proposal which you seem set on, but is actually rather problematic: the "starter loan".

Don't do that.

The problem is this: providing a starter loan will only have a relatively small impact on the total amount they pay on their auto loan, while increasing their monthly outgoings.

Every loan I've ever seen is set up so that the monthly payment is always the same, no matter what. Giving them a starter loan that they turn around and use to pay down their existing loan will decrease the principal on that loan, and thus the total cost of the loan, but won't change their monthly payments. So they would still need to make the same payment on the auto loan each month, and then pay back your starter loan on top of that.

Having a larger committed outflow each month might force them to cut their discretionary spending, but it might equally lead to them failing to pay you back as expected.

Assuming you are willing to go forward with the loan, but still want some measure of assurance they are really working towards better financial health and not just milking you for cash (intentionally or not), I would recommend telling them you would be willing to consider the loan only if they commit to paying more than the minimum amount on their existing loan for a number of months equal to whatever you had in mind for the term of the starter loan. Agree to a specific amount and a number of months with them.

If they agree, be sure to review their payment history with them to confirm they were able to consistently follow through before providing the loan. If you are already reviewing their finances and helping them get to a better spot, this could be a great way to reinforce that; roll confirming they make the additional payment each month into a session where you review how they did with their budget the previous month and plan the next month's budget.

Answer 7

If nothing else, consider this:

If you pay off their loan then their credit will shoot up a bit and they will have newfound "spending power".

I would bet they'll justify a new loan on something else they "need" and then drag their feet in paying you back.

Every time you pester them then you will be the bad guy. You have minimal legal leverage unless you sign a binding loan contract which appears on their credit report. If you get a binding contract then have fun dealing with the IRS when tax season comes.

You've made the mistake of letting them know you have a large sum of cash sitting around; it's like blood in the water for sharks.

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Mentally, you should prepare yourself by replacing "loan" with "gift" in all of your thoughts and consider whether it is something you wish to endure.

Sorry, but there are too many "Loan to/co-sign for friend/relative" sob stories on this site for me to have a positive outlook on your situation.

Per https://www.investopedia.com/do-s-and-don-ts-of-lending-to-friends-and-family-5088469

According to a 2022 survey by Creditcards.com, 42% of respondents surveyed said they had lost money through loans made to friends or family members.

Note: Yes, I am aware that respondents of such surveys might typically favor people who have had a bad outcome much in the same way a person is more inclined to share a bad experience than a good one.

Answer 8

This is peripheral to the question proper but possibly of substantial relevance to the situation. And maybe even valuable.

How much mony is involved?
It is very likely, based on many similar past queries that I've seen, that the car cost is far higher not only than they can sensibly afford but than they sensibly need. Car values decline savagely with age in most cases and if the car is new or near new it's likely that they will pay several to many times its final value by the end of the loan period.

To some (or many) a car is in some manner a status symbol - having the latest or greatest or prettiest or fastest ... adds perceived value to their life.
IF this can be overcome, and it often can't, then a far lower cost car will often serve the real needs and allow them to accumulate money to use for a costlier car in due course. If they do this and cannot manage to save money then there are other problems.

A car need not be a "beater" to be far cheaper. If 'latest model' is not the aim then a 10 year old and maybe even 20 year old car is liable to be overall more cost effective in many cases, after repairs and maintenance are included. (I drive an almost 20 year old car and maintenance costs have so far been minimal. (Being a Toyota helps :-) )).

Exploring this area and managing expectations may be of substantial value.

Answer 9

Do you want a financially sound answer? just apply an interet rate equal to inflation. You don't lose money (on this idiots' bet, idiots as per your words). Otherwise sooner or later they will get an offer for a loan 0.5% cheaper than yours and they will think "look, that @dsollen is screwing us with an higher rate ... not really a friend".

No one loans money with interests equal to inflation rate (for obvious reasons).

Plus, since they have incomes barely covering the expenses, they will feel like paying back a loan is a burden, and they are paying back to you, not to the bank... in stressful times expect them to ask you to pause the loan (probably indefinitely), because you know, you are not a bank, you do not do this for a living, so you can show some empathy.

The bank applies a risk-based interest rate because they have plenty of customers, not because they do a bet on the single customers.

The risk of losing money when lending to a friend is on the order of 99%, or larger, so no interest rate would compensate that, not even if you are giving a loan to 100s of friends.

If you invite them for dinner one day a week, for a year, strictly asking not to bring anything, you would save them tons of money and you will keep the friendship.

Or, if you want to have an higher chance of seeing your loan back from them, just "invest" the same amount in lottery tickets or other gambling things. If you win, you will get your money back and you can give them the difference. if you loose ... well, that was anyhow the most likely outcome of lending money to people with income barely covering the expenses...