Applicable Federal Rate (AFR)

The Applicable Federal Rate (AFR) is the minimum interest rate that the United States IRS requires for private loans. Think of it as the government's official “no-free-lunch” rate. Its primary purpose is to prevent tax avoidance. Without the AFR, a wealthy parent could give their child a $1 million “loan” with zero interest, which is functionally a gift, allowing them to bypass the gift tax. To stop this, the IRS says that if you lend money at a rate below the AFR, it will treat the transaction as if you had charged the proper rate. This means the lender may have to pay income tax on the “phantom” or imputed interest they didn't actually receive. The IRS publishes these rates monthly, and they are based on the average yields of outstanding U.S. Treasury Securities (T-bills, T-notes, and T-bonds), which are considered among the safest investments in the world. This direct link to Treasury yields makes the AFR more than just a tax rule; it's a powerful economic indicator for investors.

The IRS doesn't just publish one rate; it provides a set of rates each month to reflect loans of different durations. This makes sense—a 20-year loan is different from a 6-month loan. The AFR is broken down into three main categories:

• Short-term rate: For loans with a term of up to 3 years.
• Mid-term rate: For loans with a term over 3 years but not more than 9 years.
• Long-term rate: For loans with a term over 9 years.

For each of these terms, the IRS also provides slightly different rates depending on how often the interest is compounded (annually, semi-annually, quarterly, or monthly). When you're structuring a private loan, you simply look up the latest AFR that matches your loan's term and compounding schedule. Remember, the AFR is the minimum floor. You are always free to charge a higher interest rate, and in many cases, you probably should to compensate for risk.

While the AFR is a creature of the tax code, a savvy value investor can use it as a powerful mental tool for making smarter decisions. It's all about understanding your baseline and making sure you're getting paid for the risks you take.

At its heart, value investing is about buying assets for less than their intrinsic worth. But how do you decide if a potential return is good enough? The AFR offers a fantastic answer because it serves as an excellent proxy for the risk-free rate of return. Think about it: if the long-term AFR is, say, 4.5%, you could theoretically lend money to the U.S. government (by buying a Treasury bond) or a highly trusted family member and earn that return with virtually no risk. Therefore, any stock or business you consider buying must offer a potential return that is substantially higher than the AFR. That extra return is your compensation for taking on the risks of business cycles, competition, and management errors. If an investment only promises a return close to the AFR, a value investor would walk away. Why risk losing your capital for a reward you could get almost for free? This difference between your expected return and the risk-free rate is a critical component of your margin of safety.

The AFR is also incredibly practical for investors who are building and transferring wealth.

• Family Loans: As a value investor, you might want to help a child with a down payment on a home or fund a promising business startup. Using the AFR allows you to structure the loan formally and legally, avoiding any trouble with the IRS. It's a clean, tax-efficient way to provide financial support while teaching sound financial principles.
• Seller Financing: When buying a small business—a classic value investing scenario—you may encounter seller financing, where the previous owner lends you part of the purchase price. The AFR is the minimum acceptable interest rate for this type of transaction in the eyes of the IRS. Knowing the current AFR helps you negotiate and structure a deal that is fair and, most importantly, tax-compliant for both you and the seller.