Minimum Interest Rate vs Max Rate

UsuryYou probably know that when you make a personal loan to someone there is a maximum interest rate that you can charge. If you charge too much, that’s usury and that makes you a loan shark. Loan Sharks go to jail, and you don’t want to go there! Usury refers to the practice of charging a very high interest rate that is deemed unreasonable. Each state has a different approach to usury laws and different standards for what is unreasonable. California’s usury limit is now generally 10% per year with some exemptions. 

But did you know that legally there is also a minimum interest rate you need to charge someone you lend money to? I sometimes get calls from parents that want to help their kids buy a home. The conversation goes like this, “Hey Mark, we know you and Viv are the best realtors in San Carlos and possibly the world and we need your help. Junior needs a home in San Carlos, and we want to help him, but interest rates are so high. So, we thought we’d buy the house using cash and junior could pay us back monthly at a low interest rate.”


That’s when I have to give mom and dad the Applicable Federal Rate (AFR) speech. AFR is the minimum interest rate that the Internal Revenue Service (IRS) allows for private loans. Each month the IRS publishes a set of minimum interest rates that the agency considers the minimum market rate for loans (Rate Tables). There are short vs. long term rates so you need to select the correct AFR for whatever loan you’re making.

Any interest rate that is less than the AFR can have tax implications. These rates are slightly less then your typical 30-year fixed mortgage rate. If you’re making a family member or friend a loan then you have to charge the AFR or slightly higher, but not too high because then you’re a loan shark and you know where they go!

So what if you violate the minimum interest rate AFR rules? Well, several things can happen. First, there is imputed interest to the income to reflect the AFR rather than the actual amount paid by the borrower. This means you’ll pay taxes as if the interest income you collected was at the AFR and not whatever measly amount you really charged. Second, if the loan is more than the annual gift tax exclusion, it may trigger a taxable event, and income taxes may be owed. Depending on the circumstances, the IRS may also assess penalties.

Work Around

Now if you want to charge more interest than what’s allowed for a personal loan and not go to jail, then you need to open up an LLC. Then the LLC will make the loan, this is no longer a personal loan and avoids usury laws. This method might also work when the minimum interest rate you want to charge is below the AFR. Please verify this workaround with an attorney or accountant as laws change over time.

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