Factors to consider before you make the loan
Loaning Money to Adult Children
by Paige Estigarribia
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Your adult child asks you for a loan. On one hand, you love your child and want the best for him/her. On the other hand, what about your own finances? Should you loan money to your adult children? And, if so, how should that loan be set up?
To help us understand the ins and outs of loaning money to your adult children, we spoke with Brian Fricke, CFP, and author of Worry Free Retirement: Do What You Want, When You Want, Where You Want. He addressed our questions on this important and sensitive family topic.
Q: What factors should be used to evaluate whether loaning money to an adult child is a good move?
Brian: In the book The Millionaire Next Door, the authors identify one of the biggest mistakes millionaires make with their grown adult children: providing them what they refer to as economic outpatient care. So the first thing you should consider is whether you are taking care of the symptoms of poor financial decisions or poor money management. Would an independent third party, like a bank, be willing to lend them money?
We always tell our clients that if they do loan money to a friend or family member that they should mentally think of it as a gift never to be returned to them again. Document, in writing, the terms of the loan, but don't let the loan destroy a family relationship or valued friendship.
Q: What types of terms are appropriate for loaning money to an adult child?
Brian: Loan terms should be flexible and can be creative depending on the circumstances. For instance, one of our clients held the first mortgage on a home owned by their son and daughter-in-law. The "kids" wanted to sell and buy a bigger home, as they had started a family and had quickly outgrown their current home. The only problem is they were underwater based on what the home would sell for today. Our clients were tempted to either have the "kids" deed the home back to them and turn it into a rental home (which they really didn't need or want) or let them sell the property and "forgive" the shortfall. Basically agree to a short sale.
Instead, we recommended that they allow the kids to sell the home and issue a promissory note back to mom and dad for the "short sale" amount that the sales price of the home did not cover. This would allow their children to maintain their dignity and self-esteem knowing that they were NOT bailed out by mom and dad. It also forced the kids to take care of their problem instead of handing their problem over to mom and dad.
Just remember that the IRS says if you loan money, you must charge a certain level of interest, depending on the length of the loan. If you don't, the IRS will impute (assume) a certain level of interest and add that to your taxable income. So it's best to charge and document some level of interest. This is an item the IRS checks on your tax return.
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Q: What are some things people might overlook when considering whether to loan money to an adult child?
Brian: The biggest thing people overlook when it comes to loaning money is the reason why they need the loan. If it's to pay off large credit card balances with high interest rates, you're treating the symptom, not the problem, which in this case would be poor spending habits. Chances are that they'll rack up high credit card balances again and still owe you money.
Q: Are there ever any instances where it would not be a good idea to loan money to an adult child?
Brian: I would never loan money to an adult child if it was to bail them out of poor financial decisions. They didn't dig themselves into the hole overnight, so they can't expect to climb out of it overnight either. You also take away a sense of independence, self-esteem, and self-worth that comes from knowing that they took care of their own problems without needing loans or gifts from anyone else.
Q: What can a parent do if an adult child cannot repay the parent's loan?
Brian: If the loan is in writing, you could get a judgment, which would allow you to garnish wages. If collateral was pledged (car, house, etc.), you could seize the collateral. But, if you do this, you also run the risk of damaging your relationship with your friend or family member, which is why we always tell our clients to think of family loans as gifts. If they get repaid, well, that's just a pleasant surprise. And never make loans to family members or friends with money you need for income or your own financial security.
Loaning money to your adult children or other relatives can be a tricky issue. Understanding what you're doing and the possible consequences are very important.
Reviewed June 2017
Paige Estigarribia is a writer for The Dollar Stretcher who enjoys writing about food, frugal living, and money-saving tips. Visit Paige on Google+.
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