Social Lending

Oct 4, 2007 by Adam C. Powell, Ph.D.

Many readers may have money in CDs (certificate of deposit) or savings accounts paying low interest rates (1%-5.5%). Many readers may either have debts, or know others who have debts that have financing charges substantially greater than the return of a CD or savings account. If you have excess capital earning a rate of return that is less than the interest rates on your debts, the obvious solution is to use that capital to pay down your debts. However, if you lack debt, the best thing to do with that capital may be less obvious. The problem that many investors face is that the cost of borrowing capital from a bank is substantially higher than the amount that can be made by lending capital to a bank. Using Prosper.com, or informal means, it is possible for people to narrow this gap.

 If you have a reliable friend or family member in need of capital, it makes sense to offer them a loan with an interest rate that is greater than the rate you would get by buying a bond or CD of the same duration as the loan, but less than the interest rate that the person is currently paying. For instance, if a person has credit card debt that is costing them 14% per year, and the best CD you can find pays 5% a year, both of you would be better off if you provided the person with a loan at 9% a year to use to pay off the debt. The main risk in these circumstances is the risk of default. A bank is virtually guaranteed to meet its obligations to the holder of a CD or savings account, while an individual is not guaranteed to pay back the desired rate of return.

 In order to mitigate the risks of non-repayment, I would suggest two guidelines to the reader. First, only loan money to people whose income exceeds their expenditures. If someone is not in the process of accumulating capital, but instead is continually becoming more indebted, they will never have the excess cash necessary to pay you back. Second, it is far better to loan money to people who plan to invest it in production than to spend it on consumer goods. Investments have the (risky) potential of increasing the borrower’s future income. When people borrow for consumption, it is essential to ask why they needed to borrow, and could not save for their consumption in the first place. If the person has adequate disposable income to potentially save for the consumption, but has not been able to do so, as the consumption must occur in the immediate future, a loan may be warranted. If it is not clear that the person could ever save the money in a reasonable length of time, the loan may be a poor idea.

When providing loans to friends and family, it is very important to keep the terms of the loan both clear and formal. That way, there can be no ambiguity in the expectations of any of the parties involved. Once a contract has been drawn between the parties, it might even help to get it notarized. CircleLending.com has packages designed to help people officiate these types of loans. The loan should be treated as seriously as if it were made with an outside party, so that expectations of repayment are maintained. Also, it is important for the lender to make sure that he is in compliance with usury laws. Usury, the act of charging an interest rate that is too high, is enforced on a state-by-state basis. Thus, the usury limit varies by location. (Banks get around this restriction by placing their loan offices in states that have very liberal usury restrictions.)