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What Is the Applicable Federal Rate (AFR)?
Let me explain the Applicable Federal Rate, or AFR, directly to you. According to the IRS, if you're making a private loan, you must charge at least this minimum interest rate, which the IRS publishes every month. Since loans come in different lengths, the IRS provides several AFRs based on the type of loan.
Key Takeaways on AFR
Here's what you need to know about AFR in straightforward terms. These rates are an interest index the IRS puts out monthly. Lenders rely on them to set interest for below-market loans. For personal loans, the interest rate has to match or exceed the applicable AFR, or you'll face extra taxes as the borrower.
How the IRS Determines the Applicable Federal Rate (AFR)
I want you to understand how the IRS sets the AFR, as it helps when you're starting a personal loan. The AFR ensures you're charging enough interest; otherwise, you and the borrower might owe more taxes and penalties.
Normally, a bank or credit union sets loan rates high enough to cover costs, make a profit, and account for risk. But with family loans, people often go below market rates to help out. That's where the IRS steps in—you have to use at least the AFR as the minimum.
If you're lending or borrowing personally, check the AFR to confirm the interest is sufficient. For instance, if I'm loaning to a family member, I make sure to charge at least the AFR, or I'll get taxed on the interest the IRS thinks I should have collected.
The IRS calculates the monthly AFR using factors like last month's U.S. Treasury obligations, and they publish it under Section 1274(d) of the Internal Revenue Code.
Types of Applicable Federal Rates (AFRs)
When you look up the monthly AFR, you'll find different rates depending on the loan's length. You apply the right one based on how long the loan lasts.
There's the short-term AFR for loans up to three years, the mid-term for four to nine years, and the long-term for anything over nine years. The U.S. Treasury bases these on average yields from debt securities with matching maturities.
Also, keep in mind that AFR listings include options for compounding periods like annual, semi-annual, quarterly, or monthly.
How to Use the AFR When Loaning Money
Let me walk you through using AFR with a practical example, as this is when most people run into it.
Dealing with Below-Market Rates
Suppose you lend money to a family member without charging interest. If the IRS finds out, they'll tax you on the interest you supposedly earned, and that amount counts against your annual tax-free gift limit.
To steer clear of tax surprises, use the AFR from the month you made the loan. Pick the rate based on the term: short-term for three years or less, mid-term for four to nine, long-term for more.
Making a Loan at the Applicable Federal Rate (AFR)
Say you're lending your sister $10,000 to repay in one year. That's short-term, so use the annual short-term AFR—let's say it's 4.16% as of April 2025. She'd owe you $416 in interest by year's end.
If you charge less than that, it becomes a taxable event. The IRS treats the full $416 as your income, and you might face penalties too.
The Bottom Line
Charging the AFR might feel like an unnecessary hassle for a simple loan between people you know. But the IRS uses it to decide if the interest is part of the loan or a gift. Reference the AFR to set the right interest rate on personal loans, or you'll end up paying extra taxes and penalties.
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