By Gary Brooks, CFP®
In most cases, I encourage parents to make sure that they are fully funding their retirement savings before giving financial support to children for college, a down payment on a home, or other reasons. But there are certain opportunities where using funds from the “Bank of Mom and Dad” (BMD) can contribute to both parents and child’s financial security.
Intra-family loans are a little used financial planning technique that can be very attractive while interest rates remain low. Once interest rates begin climbing, this option will be less attractive so it may be wise to act now if the opportunity makes financial and personal sense.
From a financial planning standpoint, there are many benefits to an intra-family loan:
- BMD, the lender, can likely obtain a better interest rate and higher income via the incoming loan payments than they would receive from CDs, money market funds or other cash saving instruments.
- The borrower can receive better terms with a lower interest rate than is available from a commercial lender. In some cases, since lenders are more stringent than they used to be, this may be the only way to obtain a loan.
- Interest paid on the loan stays within the family, not on the commercial lender’s income statement.
- In a scenario where estate and gift taxes are a concern, intra-family loans also serve as compelling wealth transfer option.
To avoid income or gift tax complications, an intra-family loan needs to follow IRS guidelines, but the loan itself can be fairly simple. Like any loan, you need to make sure that it is properly documented with the terms (e.g., borrower, lender, length, interest rate) clearly established. This can be accomplished in a promissory note that creates a legal obligation.
The IRS provides loan guidelines for BMDs, including an interest rate minimum set monthly. This is called the applicable federal rate (AFR). The rate depends on the length of the loan. As of October 2017, the AFR for monthly compounding of a short-term loan (36 months or less) is 0.94 percent. A loan from three to nine years has a minimum interest rate of 1.37 percent and loans longer than nine years presently must charge at least 1.83 percent. (Click here to get the latest AFR.)
These interest rates are almost always lower than those available from a commercial lender. But, the rates are only minimum guidelines. Each BMD can set its own rate further to even out the benefits for both parties.
For example, assume that a child has student loan debt at 6 percent or a car payment or credit card debt, and the BMD has an equivalent cash amount that could earn more interest than it currently does. The BMD can loan the money at a rate that earns more interest than a CD or money market account – perhaps 4 percent over four years – and the child gets a large break on the interest component of his/her debt.
There are many other circumstances where dual benefits apply. In today’s expensive housing market, many people are unable to refinance their homes, because their house appraises for less than the balance on their loan. A BMD loan could help alleviate this situation. This usually gets into the territory of larger intra-family loans and may not work for many people, but can provide relief for some. If it is a mortgage loan, the BMD loan has to be secured by the home in order for the lenders to deduct interest on their tax return.
Additionally, as long as the minimum AFR is applied to the loan and the payments are actually made, no gift taxes apply. So, BMD offers another estate planning option for wealth transfer.
Certainly, mixing family and money can create unnecessary drama. However, if done correctly, an intra-family loan should result in a mutually beneficial outcome.
A similar version of this article was first published in The News Tribune in May 2011.
Gary Brooks is a certified financial planner and the president of BHJ Wealth Advisors, a registered investment adviser in Gig Harbor. Reach him at email@example.com.
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