Watch for Pitfalls When Lending Money
If you are planning to lend a friend some money, don’t be greedy when you decide how much interest to charge.
It is not only bad manners to charge a friend high interest; it may be illegal.
California has what is known as a usury law. Usury is the charging and receiving of interest on a loan in excess of the legal rate. It’s an important enough law to be found in the California Constitution, which contains a provision describing the maximum interest rate that most people can charge on a loan.
Severe Penalty
If you try to charge too much interest, the penalty is quite severe. You don’t get any. That’s right. The person who borrowed the money only has to pay back the principal of the loan, none of the interest. And if the interest has already been paid, the borrower may, in certain circumstances, be able to sue and collect three times the interest in damages if you’ve charged an illegally high rate of interest.
The maximum interest rate you can charge on a loan for “use primarily for personal, family or household purposes” is 10% per year. A real estate loan does not fall into this category.
For other types of loans, the maximum legal rate may vary. It is either 10% or a specific Federal Reserve Bank rate plus 5%--whichever is higher. To determine the alternative rate, you add five percentage points to the Federal Reserve Bank of San Francisco’s rate on the 25th day of the month preceding the loan. That rate, according to the Federal Reserve, is currently 6 1/2%, so the maximum legal interest rate would be 11 1/2% at the moment. (Because that is higher than 10%, you use it.)
You can check directly with the Federal Reserve Bank in San Francisco. Explain that you want to know the current rate on advances to member banks under Sections 13 and 13a of the Federal Reserve Act. Then add 5% to it to determine the maximum legal rate above 10%.
If the maximum rate I can charge for household loans is 10%, one reader asked, then why do I have to pay 21% to Visa and 14% to my bank for my car loan?
They’re called exemptions. The usury constitutional provision has a long list of entities exempt from the restriction on maximum loan-interest rates. They include credit unions, banks, building and loan associations, certain agricultural cooperatives, other identified lending institutions and duly licensed pawnbrokers.
That doesn’t mean these folks can charge whatever interest they can get; many are subject to legislative regulations. For example, pawnbrokers may charge 2 1/2% per month on loans up to $200 but only 1% per month for loans more than $700.
Another Exemption
In 1979, another exemption was added. It allows interest rates higher than the legal maximum for “any loans made or arranged by” a licensed real estate broker and secured by real property.
Sometimes a financial transaction may not look usurious; it may not even look like a loan, but a court will later say it was a loan in disguise.
Courts look beyond the “form” of a transaction to its “substance.” For example, in 1964 one court ruled that a complicated sale agreement with a lease-back and an option to buy entered into between the owners of a bowling alley and a group of investors was actually a loan. The sale contract, the court said, was simply “a cloak to cover up a scheme to collect usurious (illegal) interest.”
Beware of extra charges. Courts may include prepaid interest, fees, bonuses, commissions or other hidden charges as part of the interest rate and decide that the loan violates the law. And remember, if it violates the usury law, no interest has to be paid at all.
The usury law is extremely complicated, and as one court has noted, “fraught with exceptions.”
If you are about to loan money, you should consult a lawyer to make sure that you are in compliance with it. This is one area where a lawyer is essential, especially if you are embarking on a complex financial transaction.
