Giving your son or daughter a loan can be mutually beneficial, but only if it's structure properly.
Parents often want to help their adult children who need a financial boost. Should they? It can be a great idea or a terrible idea, depending on the circumstances.
The first rule: don’t let your adult child’s needs unbalance your own finances. Never let helping your child jeopardize your retirement.
On the other hand, being overly generous is a trap for affluent parents. If you provide too much financial support you could dampen their drive to become financially independent. You want to provide enough to let them grow to their true potential but not so much that they become lazy.
Loans Often Beat Gifts
It often makes more sense to give an adult child a loan rather than a gift.
It’s a good way to foster both independence and responsibility for someone planning to buy a car or a home. It’s also a wise choice if you can’t afford to give away a lot of money but can afford to make a loan.
A loan can be a great solution for a child trying to escape the burden of credit card debt or the fallout of other poor financial choices.
So-called intrafamily loans have distinct advantages. Children pay less than they likely would if they borrowed from a bank, and you can earn a decent return while helping your children help themselves.
But such loans can also cause tension in relationships if your child can’t or won’t repay the borrowed amount. To avoid later headaches, make all terms of the loan clear and set them down in writing. The child must understand that it truly is a loan, not a gift in disguise.
First, set the interest rate. Do not set the rate below the Applicable Federal Rate (AFR), a rate the IRS sets each month that varies based on the length of the loan. (Rates for July 2016 range from 0.71% for short-term loans, 1.43% for medium-term loans, and 2.18% for long-term loans.) If you charge less that the AFR, the IRS will deem it a gift, not a loan.
Next, set up a repayment schedule and decide in advance the penalty for your child failing to make payments on time. If your child defaults on a loan, there should be stated, concrete consequences, such as withholding future gifts.
At the very least, you should be very reluctant to lend again unless he or she demonstrates substantial improvement in responsibility.
The terms of the loan should be documented in a promissory note that is signed by you and your child. If the loan is intended to be a mortgage on your child’s primary home, you should hire an attorney to draft the note.
The loan must be secured by the home and recorded under state or local law in order for your child to deduct the mortgage interest on his or her tax return.
Rebecca Pavese, CPA, is a financial planner with Palisades Hudson Financial Group’s Atlanta office. She wrote about financial relationships with adult children in Palisades Hudson’s book, Looking Ahead: Life, Family, Wealth and Business After 55, available on Amazon.
Palisades Hudson Financial Group is a fee-only financial planning firm and investment manager based in Scarsdale, NY, with more than $1.1 billion under management. Branch offices are in Atlanta; Austin, TX; Fort Lauderdale, FL, and Portland, OR. Read Palisades Hudson’s daily column on personal finance, economics and other topics at http://palisadeshudson.com/insights/current-commentary. Twitter: @palisadeshudson.