How much interest to charge for lending money
By Equipo Prestafolio
How a rate is built, why the rate you advertise is not the rate you charge, and what to check in the law before setting it.
An interest rate is not chosen, it is calculated: it is the sum of what the money costs you, what you expect to lose to default, what it costs you to operate, and the margin you want to earn. If you set it "because that is what everyone charges", you are betting that the market average looks like your portfolio, and it almost never does.
A warning from the first paragraph: interest rate caps vary by country and you will not find a single legal figure here. Giving a concrete number without citing the rules in force in your jurisdiction would be irresponsible. What you will find is how a rate is built and how to know which one you are really charging.
The four components of a rate
Component | What it is | Monthly example |
|---|---|---|
Cost of money | What the capital costs you (or what you give up if it is your own) | 1.0% |
Expected loss | The share of your portfolio that historically never comes back | 2.5% |
Operating cost | Collectors, transport, phone, software, your time | 2.0% |
Margin | What you want to earn for taking the risk | 2.0% |
Minimum viable rate | The sum | 7.5% per month |
The component almost nobody calculates is expected loss, and it is the one that sinks portfolios. If out of every 100 loans you make, 5 never come back in full, you are not losing 5%: you are losing the capital of those 5 loans, which the other 95 have to pay for. Charging below your real loss is lending at a loss while feeling like you are earning.
And the operating cost is not zero even if you do the collecting yourself. Your time has a price; if you leave it out of the rate, your business only looks profitable because you are working for free.
The rate you advertise is not the rate you charge
Here is the concept that separates those who know what they are doing from those who do not: flat interest (on the original amount) versus interest on the declining balance.
With flat interest, the rate always applies to the amount you handed over, even if the client has already paid half of it back. With a declining balance, it applies to what they still owe. The first is easier to calculate. The second tells the truth.
A loan of 10,000, over 12 monthly instalments, at 10% flat per month:
Item | Calculation | Result |
|---|---|---|
Total interest | 10,000 × 10% × 12 | 12,000 |
Total to repay | 10,000 + 12,000 | 22,000 |
Monthly instalment | 22,000 ÷ 12 | 1,833.33 |
Now the important question: what effective rate on the balance are you actually charging? It is the rate that makes 12 instalments of 1,833.33 worth 10,000 today. In a spreadsheet: =RATE(12; -1833.33; 10000).
Flat monthly rate | Real effective monthly rate | Effective annual equivalent |
|---|---|---|
3% | ~5.1% | ~81% |
5% | ~8.1% | ~154% |
10% | ~14.9% | ~427% |
In other words: 10% flat per month is almost 15% per month in reality. Half as much again as the contract says, and not because anyone is cheating, it is pure arithmetic: on the final instalment the client is still paying 10% on 10,000 when they only owe 833.
This matters for three reasons:
- For you: if you compare your return against another investment, you have to compare the effective rate, not the flat one.
- For the client: they have a right to know what they are really paying.
- For the law: many jurisdictions compute the usury cap on the effective rate, not the nominal one. A flat rate "below the cap" can be far above it once converted.
The quick rule (and its small print)
There is a classic approximation to convert flat to effective: multiply by 2n / (n + 1), where n is the number of instalments. With 12 instalments: 24/13 ≈ 1.85. A 5% flat rate would be ~9.2% effective.
The table above says 8.1%. The rule overshoots by more than a point, and always on the high side. Use it for a rough sense of magnitude; to decide, use the RATE function.
How frequency is decided (and why it changes the rate)
Collecting daily is not collecting monthly divided by 30. It changes the risk and it changes the cost:
Frequency | Default risk | Operating cost | Effect on the rate |
|---|---|---|---|
Daily | Low (you spot trouble within 24 h) | High (visits every day) | Rises on cost |
Weekly | Medium | Medium | Balanced |
Monthly | High (you find out late) | Low | Rises on risk |
That is why daily credit is expensive and it is not (only) abuse: keeping someone on the street every single day genuinely costs money. What is abuse is charging the daily-credit rate without showing up every day.
Before you set the rate: the law
This is the part you cannot skip, and where this article deliberately stops giving you numbers.
Practically every country in the region regulates maximum interest, but they do it in mutually incompatible ways: some publish a maximum rate that is recalculated periodically; others define it as a multiple of a reference rate from the financial system; others distinguish between ordinary and default interest, with different caps; and in some, lending habitually requires registration or authorisation, in which case the rate is the least of your problems if you are not registered.
What to do, in order:
- Look up the rules in force on the website of your country's central bank or banking superintendency. That is the primary source; do not copy it from a forum.
- Find out whether the cap applies to the nominal or the effective rate. As you have just seen, that changes the answer completely.
- Check whether default interest has its own, separate cap (it usually does).
- Confirm whether your activity requires registration or a licence, and above what volume.
- Put the rate (nominal, effective and default) in writing, in the contract. See Promissory notes and loan contracts.
Charging above the cap is rarely "free with a bit of risk": in many jurisdictions it voids the interest on the entire transaction, and in some it turns whatever you overcharged into something you have to hand back. Which means the loan goes badly for you even if the client pays.
Summary
- Minimum rate = cost of money + expected loss + operating cost + margin.
- Expected loss is the component people forget and the one that breaks portfolios.
- Flat is not effective. 10% flat per month over 12 instalments is ~14.9% effective.
- Collection frequency changes the rate because it changes the cost, not just the risk.
- The legal cap is set by your regulator. Find it at the primary source before you set anything.
Prestafolio calculates the instalment, the schedule and the total cost of every loan before you hand the money over, so you can see the real number and not the one that sounds good: see Simulating a loan and Loan types.