What is a Fair Interest Rate for Money Loved Ones Lent You With No Interest Rate Specified?
February 25, 2010 10:17 AM   Subscribe

Despite the lender explicitly loaning me something interest-free and with no firm repayment date, I would like to offer a fair interest rate when I am able to repay them in the future. I'd like your help in figuring out what that rate would be, and your confirmation that I am applying the concept of compound interest correctly.

My parents have loaned me money throughout this recession. The one occasion my mother and I spoke of it, she said (I paraphrase here, but accurately so) that although it wasn't an outright gift, she didn't want me to worry about paying them back until I had taken care of any other financial priorities (including any credit card debt), and it was also said that there wouldn't be interest.

I'd like to, at the very least, out of a sense of basic decency, when I am ready to pay them back, offer them back what I owe them plus a decent interest rate. Problem is that I have no idea how to figure that out: I don't know how, absent their offer, to determine what a fair, or average, interest rate would be. Is there some sort of market statistic I can consult? My credit card companies are not good models to look at for answers to this question.

And how would I apply it? I've heard the word "compounded" before, but I'm not entirely sure how to apply it when I don't have the credit card companies doing the math for me.

Is it ... just to pluck figures completely out of the air, say it's a 7% interest rate (compounded monthly, right?), and the amount borrowed $100. (Much more than that has been lent.) Does that mean that the first month would be $107, the next month would be $114.49, then $122.51, $131.09, $140.27, etc.? In other words, multiplying your balance each month by 1.xx, where xx is the interest rate in decimal form?

Since I'm anonymous and thus can't just wait to address this until I see whether or not it develops, I'll just ask ahead of time that the thread not derail with answers saying that I don't need to do this and should just accept it being no interest. I understand the sentiment behind such comments, and if they adamantly refuse, I am not going to get into a "fight" with them at that future time about whether they take the interest or not. In fact, I expect that they are going to refuse. If they don't refuse, I'll be glad, but the thing is, I think it's the right thing to do, and when I am able to, this is how I want to first present things. It seems the menschy way to approach this.

Asked anonymously because, honestly, I'm embarrassed as all fuck that I'm the age I am and borrowing from my parents (despite having had savings, etc.). I know I'm not alone in doing so, but, honestly, I really don't want my name publicly associated with this circumstance.
posted by anonymous to Work & Money (14 answers total) 2 users marked this as a favorite
If you want to compound monthly, you have to multiply by a monthly interest rate. 7% would be a reasonable annual interest rate. A reasonable monthly interest rate would be 7% divided by 12, or 0.58%. So you would compound by owing $100.58 after one month, $101.17 after two months, and so on.

If you want to use some sensible market rate, the so-called "Prime Rate" would be a good choice. Historical prime rate here.
posted by Perplexity at 10:23 AM on February 25, 2010

THat 7% should be yearly. The monthly rate can be figured one of two ways: 7% divvied up among 12 months (so .07/12 or .005833) or 7% divvied up amongst the 365 days, times the number of days in the month. Really, just use the first one; it's close enough.

So every month, multiply by 1.005833. Or if you want to do it all in one shot, figure out the number of months (n) on the loan, and take 1.005833 to the n power. Multiply the loan amount by that.
posted by notsnot at 10:27 AM on February 25, 2010

It's great that you are thinking of this. There is actually a minimum interest rate that they are supposed to be charging you if it is not a gift. I would go by this minimum rate or at least use it as a guideline. It comes from the Applicable Federal Rates which are published every month. The percent will depend on the length of the loan.

This guide has a bit more of an explanation:
posted by beyond_pink at 10:28 AM on February 25, 2010

You might not want to hear this, and it's probably unnecessarily nitpicky, but you seem very focused on "the right thing to do". It is my understanding as a layperson that the recipient of repayment of a loan needn't treat the repayed principal as income, but that interest would be income. So by paying interest, it might be that "technically" it then triggers a tax obligation to your parents. Now, I can't say whether they would feel obligated to pay the income tax and whether it would ever be a practical real-world issue. But, when you think about really wanting to do the "right thing" remember that your right (moral) thing may create a right (legal) obligation. I don't think that forcing someone into that kind of situation when they really don't want to be there is menschy at all. Maybe save your parents the technical tax obligation and help them out with a major household project, or spend a nice day with Mom doing something special she'll really enjoy.

I am not intending to engage in premise-questioning, but when I read your question this angle popped into my head immediately. If you've thought about this, considered it and ruled it out I apologize. I recognize that your question is one of "how do i?" and not "should i?".
posted by bunnycup at 10:35 AM on February 25, 2010

(On the other hand, also what beyond_pink said as a counterpoint.)
posted by bunnycup at 10:39 AM on February 25, 2010

Your intentions are noble and you are not - by far - the only one in such a circumstance these days.

A good way to think about this is what they are sacrificing in order to assist you. I will assume that they are drawing from savings and not taking the shirts of their backs to aid you. The "opportunity cost" of lending you the money might best be represented by what they will have "lost" if they hadn't. Given that savings, money market, and certificate of deposit rates are pitifully low these days (<2% per year), there isn't much difference between putting it in your hands and in those of a bank. Indeed, 1.5% per year, even compounded, is pretty trivial.

I think being more kind, helpful, and attentive now would be the best way to show appreciation (not that you aren't kind, etc., just one could always be more so) and would far outrank arm-wrestling over trivial interest.
posted by fydfyd at 10:41 AM on February 25, 2010

What about a really nice gift at the end of the process? You could tabulate to yourself a fair interest rate (track prime interest rates, if you're from Canada, you can get them here) and with your last re-payment, include a gift which would equal the value of the interest you paid. You never have to have a conversation based on interest with them at all.

Your parents made the loan to help you out financially; I doubt they'll feel good about making a profit off their child. A gift prevents them from having to feel the guilt of having made interest and also shows your appreciation. It's just a thought.
posted by Hiker at 10:55 AM on February 25, 2010

Don't overthink this plate of beans. If your personal propriety won't let you accept your parent's generous terms, just stick to a simple (non-compounded) interest.
posted by mkultra at 11:11 AM on February 25, 2010

A good bottle of scotch is pretty good interest
posted by Large Marge at 11:37 AM on February 25, 2010

You asked what a fair interest rate would be. For comparison, a bank would charge its best customers the prime rate mentioned by others above. Given what you have said about the terms on which your parents have loaned you this money, I would suggest setting the interest rate somewhere between prime and prime + 2%. Track the prime rate and adjust your calculations monthly if and when it changes (it will, and upward, probably starting at some point toward the end of this year, but IANA/YBanker).

FWIW, I am doing precisely this at the moment.
posted by onshi at 1:38 PM on February 25, 2010

Just to be clear on how to calculate the amount you would pay back:

P = amount you borrowed
r = *annual* interest rate (like 2%-10%, or what ever you decide)
n = number of months you had the money for

A = P( 1 + r/12) ^ n

If you borrowed $1000 for 16 months at 5%, it would be:

A = $1000 * (1 + .05 / 12) ^ 16 = $1068.79
posted by gus at 3:10 PM on February 25, 2010 [1 favorite]

In à similar situation, with an explicitly interest-free family loan I have paid back so they got equivelant to what a decent saving account would have given them. Slightly above savings rate is still way below lending rates so it is win-win and was non- offensive to them (they didnt feel treated like a bank).
posted by Iteki at 3:46 PM on February 25, 2010

I prefer the bottle of scotch, or dinner-out method of interest on this kind of thing. It prevents it from being a business transaction, and turns it into family helping you out, and you thanking them.
posted by cschneid at 4:12 PM on February 25, 2010

Economically, in hindsight, you should should be thinking about what your mom's opportunity cost was of loaning you the money ($x), and then decide if her loan to you should have been at a riskfree rate, or if she should receive a premium for your risk of default.

At the low end of the spectrum, you could assume she could have (alternatively to loaning it to you) held the money in a riskfree savings account. If this was a recent loan from 2008 or later, this would be a low rate (like 1% per annum), as rates have been low during this period. You could track this with many measures but you can see the history of the rates of some popular online banks here and pick something middle of the pack. If you wanted to get technical, you could figure out the actual rates of whatever banking institution your mom uses.

At the higher end of the spectrum, you could have assumed that she might have invested in some longer duration instruments, like CD's, bonds, treasury notes or bond funds and earned higher rates than a savings account. You could also factor in your creditworthiness into the equation and decide that for taking you on a credit risk, your mom deserves an even higher rate than she would receive if she loaned money to a bank or to the U.S. government. You might want to think about something like 4% to 10% here, which would be your actual cost of funds if you secured a home-equity loan or a bank loan.

As far as compounding, don't do it monthly (that is only used for purposes of providing cash flow to customers who want to see their money gain monthly). Just apply it annually and roll the interest into the following year's principle. Then for the final year, pro-rate the interest rate based on the portion of the year (e.g., the final 3 months would just earn 25% of the rate).

Or just forget the interest and buy her a nice bottle of wine and a nice dinner.
posted by jameslavelle3 at 7:00 AM on February 26, 2010

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