Mother (and father), can you spare a dime?
Your adult child may need your financial help now more than ever. Be sure you consider these questions first.
NEW YORK (Money) -- I could not have bought my first house long ago without borrowing the down payment from Mom and Dad. Their loan got me started down the home-equity path, and it's paid dividends ever since.
Yet, at that young age, I had no idea how difficult it would be to repay them, and one Christmas they graciously wiped the slate clean as a gift. I was relieved. But I was also humbled by the weight of debt that no bank would accept - and now am thankful for that early lesson in the pitfalls of borrowing money from family.
As late-stage teens, my own kids are fast approaching the day when they'll need thousands of dollars for a car and, soon after, tens of thousands for their own down payment. Lately, I've been thinking about how I might handle such requests.
Perhaps your grown children are already hitting you up. In the U.S., about $45 billion of parent-child loans are extended every year, and that borrowing - used for everything from paying down student loans and credit-card debt to funding a new business - is certain to grow given the tumultuous state of the economy. These are your kids. You want to help. But precautions are in order. Before you lend a dollar, ask yourself these questions:
Your ability to lend to a grown child, or any family member for that matter, has likely taken a gut shot in the past six months. The stock market is down sharply. Home equity has eroded. Jobs are less secure. Many corporations have slashed their dividends - and your income if you are a shareholder. Short-term yields are falling (perhaps further cutting your income). Meanwhile, your taxes may be going up under the Obama administration. So reconsider your resources. Nine in 10 boomer parents have helped their adult children financially, according to a study by Ameriprise - even though to do so 40% of them had to draw down savings while 17% had to take a loan. But sacrificing your security to make things easier for your child is rarely a smart idea.
About 14% of loans between family and friends end up in default, far more than the under 3% of consumer bank loans that go bad. So understand that you may not get paid back. That may not bother you if the child who is borrowing is in your will anyway and you can afford the loss. But the IRS views loans that are forgiven as gifts, subject to a limit of $13,000 this year ($26,000 if you are married) per recipient before the gift tax kicks in. If the loan is small enough- and you really can afford to lose it - consider keeping things simple by making it a gift from the start.
Helping a son or daughter who's just been laid off cover the rent for a few months is a more compelling reason to lend money than helping said child pay for a winter getaway to a sunny locale with friends. Alarms should also go off if your offspring is asking for a third loan in your lifetime - maybe he or she has a larger, underlying financial problem that needs to be addressed, suggests Karen Ramsey, author of "Think Again: New Money Choices, Old Money Myths." "Tell her you won't loan her the money but you will pay for credit counseling or a visit with a financial planner," Ramsey advises. "We love our kids but at some point the dependency has to stop." If saying an outright no is too difficult, blame your decision on forces outside your control - like the slumping stock market or a financial adviser who has warned you and your spouse that you're in danger of outliving your money.
If you do decide to extend a loan, set it up for success. That means choosing a reasonable interest rate and repayment schedule. If you lend more than $10,000, the rate must be equal to or greater than what's called the applicable federal rate or you will run into gift-tax issues. You can find this rate, which fluctuates monthly, at irs.gov. Currently it ranges from 1.6% to 4.2%, depending on the length of the loan. If you charge less, or nothing, the IRS will treat the value of the forgone interest as income to you and a gift to your child.
Don't leave the repayment period open-ended. Such personal loans default nearly three times more often than those structured with monthly payments, says Asheesh Advani, CEO of Virgin Money USA, a peer-to-peer loan facilitator. "They cause all kinds of family stress," he says. "You end up wondering how the borrower can possibly take a nice vacation when he owes you all that money. But that doesn't come up if he's making regular payments."
Put everything in writing, spelling out the loan amount, interest rate and payback schedule. It's also a good idea to tell your other kids about the loan so they're not surprised and possibly resentful if they find out about the arrangement. You can purchase a simple loan document from the Web site nolo.com for about $7.50. Fill in the terms and have all parties sign it.
You can also set up a personal loan through Virgin Money, which will handle details like billing and collection for a setup fee of $199 and a small monthly fee (for mortgages, the fees range from $649 to $2,299). Using a loan facilitator like Virgin probably doesn't make sense for a small sum but works well for larger amounts, especially a mortgage. Then too, in the case of a mortgage your child will be able to deduct the interest, and if things go really badly you'll have a tax-deductible loss. Sure, it's a bit formal for a loan between parent and child. But putting everything in writing is just part of keeping the peace - never easy when blood and money mix.Send feedback to Money Magazine