Question: I have a question. Basically, I have the chance to lend $1,000 to someone for 2 years @ 7.5% compounded monthly. The monthly payments for this person will be $45. After the two years I will have received my principle back ($1,000), plus $80 interest for a total of $1,080.
Now for the question. How do I correctly determine the annualized rate of return to compare to other investments….Here is what I have done so far, but I am quite sure it is wrong.
Loan duration is 2 years with a starting investment of 1,000 turning into 1,080 for an annualized rate of return of 3.92%. To get this 3.92% figure, I used a financial calculator with the following inputs: N = 2 Present Value = -1,000 Future Value = 1,080 Compounds per year = 1 Payments per year = 1
This just doesn’t seem like the correct calculation to me. Is this the correct way to calculate annualized rate of return for a set amount of monthly payments – as in this case?
Answer: I’m also a little nervous about anyone loaning money directly to another person. I’d definitely get some collateral, like the borrower’s car.
I’ve seen friendships break up over loans, and not only that, the money wasn’t paid back either, leaving bad feelings and guilt. Personal loans can teach the meaning of the phrase “neither a borrower nor a lender be.”
I think it might be smarter to forget about loaning the money. I’d send the would-be borrower to a bank or other professional loan source. I think the borrower might also be able to find as-good or better interest rates. I’m also wondering why the borrower wouldn’t use a bank, and also wonder if the borrower had credit problems that prevented using a bank, which would be a bad sign for the lender.
Rather than make a personal loan, I’d try to steer the borrower elsewhere. I could put the $1,000 in a savings account or CD and get a guaranteed return and know I’d be guaranteed to get my $1,000 back also.
OTOH, the personal loan here could all work out. But I think it’s risky and I’d ask for and get collateral. I’d also make sure to get the whole loan contract on paper and make sure the collateral is transferred to the lender.
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