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P2P Lending and Private Loans with Life Insurance

With banks and other businesses reeling from the effects of the pandemic, banks have continued to tighten their lending standards, making it harder for people to obtain loans. So how can borrowers and lenders come together to resolve their mutual financial goals in this current financial landscape? One answer may be private loans, particularly those between individuals.

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Private money lending, also known as Peer-to-Peer lending, has skyrocketed over the last 10 years. Business Wire reports that the global peer-to-peer lending market grew by 25% from 2014 to 2019, and is projected to continue growing over the next five. For an industry that was virtually non-existent 15 years ago, there is clearly a strong demand for lending platforms that meet the needs of both lenders and borrowers.

Peer-To-Peer Lending

Peer-to-peer (P2P) lending is typically facilitated through 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 creditworthiness. The borrower then submits a request for funds and waits to see if lenders 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 take part 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. Remember that as the lender, you should evaluate the creditworthiness of the borrowers and weigh the risks of default against expected returns. Because if you’re lending this way, it’s likely that you 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, taking this approach can quickly become a full-time job). 

According to one of the leading P2P websites, current rates charged for unsecured loans to the highest-rated borrowers are between 3.7–6.9%, and lenders choosing these risk categories can expect the lowest default rates. For high-risk borrowers, the interest rate charged is much higher—borrowers in these risk categories are charged between 7.78-13.48% because the default rate for these borrowers hovers around 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. Even so, P2P lending companies represent another way that innovation and cooperation provide new opportunities for individuals to prosper.

Private Family Loans

Private loans can also be beneficial for family members. These special loan arrangements, often referred to as intra-family loans, generally have more relaxed terms than the P2P marketplace. However, even among family members, loans have potential tax implications that are governed by the IRS.

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 fewer have a minimum AFR of 0.12%, while loans of 3-9 years in duration have an AFR of 0.89-1.56%, and those longer than nine years must have a minimum annual interest rate of 1.98%.

Even with the applicable IRS restrictions, private family loans can be beneficial for both lender and borrower. For parents lending the money, there is the opportunity for greater returns than what they are getting from 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. 

Children also get significant advantages from family lending–often lower-than-market interest rates and more favorable repayment terms.

A Note For Family Lending

Although families often execute loans with nothing more than a handshake and an informal verbal agreement, we strongly recommend 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. 

And, 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 record-keeping is valuable confirmation in the event of an audit.

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 allows for additional premiums to be credited to the cash value account. Since these accounts often pay annual dividends* at a competitive rate and accumulate on a 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, it’s wise to consult with the insurance company or your life insurance agent before making additional deposits.

* Dividends are not guaranteed.

How Can We Help?

If you’re interested in learning more about how whole life insurance can facilitate private lending, or how to start saving into a whole life insurance policy, Prosperity Thinkers is here to help. You can contact us at welcome@prosperitythinkers.com with your questions or to schedule time with Kim.

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