Lasting Situations of Wealth

A November 9, 2010 article from the Reuters news service reported that the average rate of return for all Certificates of Deposit dipped below 1% for the first time since 1952. At the same time, banks have tightened their lending standards, making it harder for people to obtain loans. How can these two parties resolve their financial dilemmas? One answer may be private loans, particularly those between family members.

As reported by Anne Tergesen in a November 27/28, 2010 Wall Street Journal (“Mom, Dad, Can I Borrow $140,000?”), “business is booming at the Bank of Mom and Dad.” For parents lending the money, there is the opportunity for returns greater than what they are getting from money placed in CDs or savings accounts. And while these returns are not guaranteed, parents are likely to know the trustworthiness of their borrowers – after all, they raised them. For children, the advantages to borrowing from parents may be lower-than-market interest rates, and favorable payment terms.

Even though family loans are often executed with nothing more than a handshake and an informal verbal agreement, it is strongly recommended that any family loan agreement be documented in a written contract, for several reasons. A document provides a written record for both parties and clarifies the terms of the agreement, including whether any property is pledged as collateral for the loan. In the event of missed payments or other unexpected circumstances, this information makes settling disputes easier. A contract also provides the heirs and estates of both parties with proof of the existence of the agreement. Since interest received from loans may result in taxable income, this recordkeeping is valuable confirmation in the event of an audit.

Further, according to this article, IRS regulations require a nominal interest rate that must be charged on loans to relatives in order to avoid incurring either gift or income taxes. This rate is known as the Applicable Federal Rate (AFR). Currently, loans with terms of three years or less have a minimum AFR of .35%, while loans of 3-9 years in duration have an AFR of 1.59%, and those longer than nine years must have a minimum annual interest rate of 3.35%

PEER-TO-PEER LENDING

Similar to intra-family loans are peer-to-peer (P2P) lending companies that attempt to match individual borrowers and lenders. Most of the companies are Internet-based. In a typical arrangement, a prospective
borrower provides financial information which results in an assessment of their credit-worthiness. The borrower then submits a request for funds and waits to see if borrowers are interested. The interest rate is usually determined by the peer-to-peer service, with high-risk borrowers being charged the highest rates. For a modest fee, the company takes care of the contractual issues, and serves as the custodian for payments from the borrower and disbursements to the lender(s). Lenders can take a fractional position in a loan, and some P2P lending services allow lenders to participate in loans with investments of as little as $1,000.  

In theory, using this peer-to-peer lending format could allow an individual to hold a diversified portfolio of loans made up of differing levels of risks, length of maturity and rate of return. But just like a parent making a loan to a child, the lender needs to evaluate the creditworthiness of the borrowers and weigh the risks of default against anticipated returns. You probably won’t know the borrower personally, and will have to rely on the financial information provided by the borrower (although some P2P lenders have become very thorough evaluators of those to whom they lend, but that can become a full-time job). According to one of the leading P2P websites, current rates charged for unsecured loans to the highest-rated borrowers is between 8-9%, while the default rate for this group is around 7%. For high-risk borrowers, the interest rate charged in much higher, but the default rate is closer to 20%. When the odds are 1 in 5 that a loan will end in default, this transaction cannot be considered “guaranteed,” even if the terms of the contract are clearly specified.

Because of their economies of scale, expertise and network connections, banks have many advantages over individual lenders. But P2P lending companies represent another way that innovation and cooperation provide new opportunities for individuals to prosper.  

BTW: If You Own a Cash Value Life Insurance Policy…

Many cash value life insurance policies have a paid-up additions feature (or something similar) that allow for additional premiums to be credited to the cash value account. Since these accounts typically pay annual dividends* at a competitive rate, and accumulate tax-favored basis, policyholders may realize a substantial

earning advantage by placing some of their savings in cash values – without the worry about the creditworthiness of an individual borrower.

One caution: Paid-up addition deposits are subject to annual limits according to Modified Endowment Contract (MEC) rules established by the IRS. Since
exceeding these limits may result in the loss of tax advantages, and because each policy has a unique MEC limit based on the annual premium, the policy’s face amount and the history of previous paid-up addition and premium payments, you should always consult with the insurance company before making additional deposits.  

* Dividends are not guaranteed.