By Julie Cole
We all want to help our children succeed and that may mean helping them financially. If
you are fed up with meager returns on your bank savings accounts and your children are in debt with steep interest rates, an intra-family loan can make the “Bank of Mom and Dad” a positive alternative. Your interest rates go up and your children’s loans would become more affordable.
There is a trend in financing homes, cars, and refinancing of student loans by parents who have a desire to help their kids keep lending costs down and increase their own returns.
Most financial planners recommend that parents should never get financially involved with their adult offspring’s finances unless their own financial needs and long-term retirement are secured. That means that parents should be willing to lose that money and not get it back. Additionally, parents should never co-sign on a loan unless they have enough current liquidity to pay off the loan or make the payments. If the kids cannot make the payments, then the potential that the parents will be making the payments, paying off the loan, or ruining their credit certainly exists.
However, exceptions can be made. Parents with enough cash (liquid cash in savings accounts) and the desire to help their kids should be able to, but should take appropriate precautions and have healthy expectations:
1. Never take money out of a retirement savings account. Any distribution from a retirement account creates a taxable event and may put you in peril during your retirement years. A retired person living on social security with only $300,000 in retirement savings is not in a position to hold a $100,000 mortgage on a child’s home.
2. Make sure there is a written contract that conforms to federal tax standards and is enforceable. Use a lawyer to give you advice and draw up the promissory note. If there is a mortgage, make sure the note is recorded and the interest rate follows the applicable federal rates (APR) guidelines. Otherwise the borrower may not be able to deduct the mortgage interest expense, or it may be considered a “gift” for federal estate tax purposes.
3. Make sure you lend your kids money for the right reasons. Helping children who are turned down from the bank because they have a lot of credit card debt and have been slow to pay is not a good reason to lend them money. You may be better off just paying off the debt for them and helping them meet the bank requirements for a loan. There are several right reasons to loan them money.
a. Help them buy their first car (usually a good used car). Many parents make an interest-free loan and allow the children to pay as they can.
b. Hold the mortgage on their children’s home that they otherwise would be able to finance at the bank. If your kids have a “great” credit rating and qualify for a 30-year mortgage at 4.2% at the bank, but you will lend at 3.2% and you are only earning 1.2% on your bank accounts, both of you can benefit and the kids save the origination fees, too.
c. Refinance the student loans. If student loan rates are so high that they will be paying for the next 20 years you may want to help. Similar to the home mortgage option, if the child has a student loan that you could finance at a better rate, this option could put both of you in a better position.
4. Take the opportunity to educate your kids. Parents should be talking to their kids about the realistic costs of home ownership, like maintenance costs and paying utility bills. Adult children who are “spend-thrifts” need to learn to live within a budget.
If you don’t have serious money discussions with your children then throwing money in their direction may be harmful. Within intra-family lending, it is crucial to have everything in writing to make sure there are no misunderstandings about repayment plans or the consequences of a loan default. Everyone needs to pay attention to the current laws and tax consequences of any financial arrangements. Only parents with enough cash should consider making loans to family and should consult with an attorney before writing a check.