You always hear the old saying to never lend money to friends or family members [1]. The reason for this is because you don’t want money to be a wedge in your relationship should the borrower skip out on payments. While I feel that this rule is a good one in theory, in practice it does have its flaws. There are times when loans to children from parents work out just fine.
When Loans to Children Work
This saying stereotypes every borrower as being unethical or not paying back loans. Not everyone is unfit for a loan from a friend or family member. Take my case. When I first started driving, I wanted a car. I didn’t have the money for one and without any credit it was doubtful I was going to get a loan. Even if I was able to secure a loan, odds are the interest rate would be sky high since I would have been considered high risk without a credit history.
My dad ended up stepping in. He loaned me the money at 0%. We agreed on the amount I would pay him back monthly and we kept a ledger to keep track of everything. He could have simply co-signed a loan, but he didn’t want the bank to get any interest. I was grateful for this and I would do the same thing for my kids. (Of course the downside of this is a continuation of a lack of credit history for me. However, this can be solved by opening up a credit card. In most cases, your first credit card [2] will have a small credit limit on it and as long as you make a few charges each month and pay it off in full, you will have a decent credit history in no time.)
Large Loans: Lending Your Kids Money to Buy a Home
Bigger Loans, Bigger Risk. The thing about my example is that it was a small loan for a few thousand dollars. What do you do if your child needs help with buying a house or a newer car? Your first option is to do what my Dad and I did and write up a basic agreement and trust that each party will be responsible with regards to the loan.
Loans to Children and Taxes. The problem with making mortgage loans to children is that many times this type of loan won’t pass a test by the IRS (Does The IRS Care If I Lend My Kids Money? [3]), meaning the interest paid on the loan will not be deductible as an itemized deduction [4]. Additionally, you could be looking at a gift tax [5] issue should the loan be drawn up the wrong way.
Getting Help From a Third Party
Today there are businesses that will solve the above issues for making loans to children and the tax implications for you. Here is how it works: you engage the third party company to draft up the loan documents. The third party company should guarantee that the documents will allow for the deduction of mortgage interest [4] and will not violate any gift tax statutes.
From there, a trust is set up where the parents will lend the child money for the purchase. The child will then pay back the trust based on the terms of the promissory note.
The benefits to the child include a lower interest rate than banks are charging as well as cash in hand. When it comes to buying a home or a used car, having cash is ideal to the seller. The benefits of a tax deduction will be based on the child’s current tax bracket [6].
For the parent, they get to help out their child while at the same time earning some interest. In most cases, this interest will be higher than what they could earn from current interest rates [7] at the bank.
As for the third party, they get a one-time fee for setting up everything. In most cases it costs roughly $1,000. Be sure to do your homework before engaging anyone though, to make certain they are reputable and will do a good job. If a company tries to charge you an ongoing fee or anything other than a one-time fee of around $1,000 I would move on to another company.
Final Thoughts
I presented a best case scenario, where the child follows through and pays back the loan in full to the parents. But we all know this isn’t always the case. You will have to think long and hard before entering into a loan agreement with your child. My advice would be to think of the worst possible outcome and whether or not you would be comfortable with that. Most times, the worst case scenario is not getting paid back, writing off the bad debt [8], and being on non-speaking terms with your child. This might sound harsh, but it is all too common.
However, if you feel your child will pay back the loan and you believe no issues will arise, then you might want to look more into a third party drafting up the documents for you. Both you and your child will benefit from the arrangement and hopefully both will be happy.