Lending money to another person is a tricky proposition on several levels. The loan may be paid back late or not at all, and relationships may be strained to the breaking point if both sides have a different set of expectations for how the loan should be treated. As a result, it's key to get everything in writing, documenting the terms of the loan, the repayment plan and the consequences of default. As an alternative, if profit is your primary motivation, peer-to-peer lending sites offer the ability to extend personal loans to strangers based on the perceived risks and rewards involved.
Friends and Family
It can feel good to help someone out of a financial jam by giving the person a small loan. However, when the time comes to be repaid, collecting can be an uncomfortable process for both sides if the borrower can't or won't fulfill his obligation. While it's safer to avoid loaning any money you can't afford to write off if needed, several techniques can help spark repayment.
Evaluate the Borrower
Much like a lending officer at a financial institution would do, consider the creditworthiness of the borrower and the use of the borrower funds before agreeing to extend the loan. You might not be able to pull a credit report yourself, but you can ask the prospective borrower to provide one for you to review. You also can ask him for details about why he needs the loan. If it's a loan to help a friend start a side business, for example, ask to see the business plan, and confirm that he plans on keeping his existing job for the time being to increase the odds he'll have the cash flow required to pay you back. If it's your grandson who wants money to buy a car, get him to write a detailed plan for how he'll get the money to pay you back. Otherwise, he could drive off into the sunset and leave you footing the bill.
Get It In Writing
Write the loan details down in a promissory note, including the length of the loan term and the repayment schedule. Getting the document notarized can accentuate the seriousness of the loan obligation, and also can prevent the borrower from arguing later that he did not understand the terms. In addition, it can avoid disagreements about whether the funds were intended as a gift or a loan, particularly important to the estate if the lender dies without the funds having been repaid.
It's not just banks that should charge interest on loans. In fact, if you don't charge interest on a person-to-person loan, it could draw unwanted attention from the Internal Revenue Service -- even if the loan is to someone in your immediate family. Waived interest may be considered a gift to the borrower by the IRS, and therefore potentially leave you subject to gift taxes. The IRS also may require you to treat some of the money as interest, even if you don't actually charge it. To play it safe, charge at least the IRS's Applicable Federal Rate, which is published online each month.
Peer-to-peer Lending Services
You also can make person-to-person loans through services like Prosper and The Lending Club that connect those looking for personal loans with others with money to lend. You'll fund your account via an electronic bank transfer in most cases.
As a Prosper investor, you decide which borrowers and loan requests meet your criteria, and loan money accordingly. The Lending Club operates in a similar fashion. Both take enough information from the hopeful borrower that helps you assess the risk. For example, the Lending Club assigns borrowers letter grades ranging from A to G. The "A" borrowers have the lowest risk of default -- and also lower interest rates. G-rated borrowers may be more likely to renege on their commitment to repay, but also offer the highest potential reward to the lender because the interest rates on those loans will be higher.
Terms for personal loans at both Prosper and the Lending Club are either 36 or 60 months, depending on the size of the loan and the risk assessment assigned to the borrower.
Diversify Your Portfolio
Your ability to make a profit using these services hinges on your ability to determine who is most likely to repay the loan as agreed, and what interest rate you're looking for. Both services suggest that you diversify your lending portfolio, lending small amounts to numerous borrowers to reduce your risk. You'll pay a loan servicing fee for the facilitating the company offers based on loan repayments, and if the borrower falls behind you may face an additional charge for collection services.