In recent posts, I’ve covered issues widows face regarding being seen as an open wallet and how to wean adult children off of financial support in cases when they’re capable of being financially independent. Today, let’s look at those instances when there are legitimate reasons for lending money to your adult children.
I won’t go into the myriad of situations for when it makes sense to lend your child money, but if you’re having trouble deciding whether you should or shouldn’t, think about this. The simplest demarcation I would use to determine whether or not to go ahead is whether you’d be giving your kid a “hand up” or just a “hand out”.
Take buying a car for example. Lending your child who just finished post-secondary school enough money to buy a basic, reliable, used car to get to and from their new job is a hand up. Lending a child who has been living at home with you, while fully employed, to buy a sports car that’s beyond what he can afford is a hand out.
Loaning vs. Gifting Money to Your Kids
There are times when it can make sense to give money to your kids rather than lend it to them. For example, if you lend your son or daughter the money for a down payment on a house, the mortgagor would include your loan as part of your child’s total debt obligations when considering if they qualify for the mortgage. In this case it may be better to just give them the money, if you can afford to.
In wealthy families, there can be tax benefits to giving your children money each year. I don’t want to get into these tax issues, because it clearly depends on what country you reside in. Canada and the U.S. treat gifts of cash differently, for example. Talk to a tax accountant first before making a decision in this regard.
Gifting money may also reduce probate fees for your estate. If you think that would be beneficial, check with an accountant or an estate planner before doling out money to your children.
Assuming you don’t have a huge excess of cash lying around, but you have a bit of savings you could help your child with, let’s suppose you’re contemplating lending your child money. You may have a few misgivings about loaning rather than gifting them money. One thing to keep in mind is that loans help foster a real-world sense of the value of money. This in turn contributes to developing a real-world sense of responsibility and ultimately independence in your child. Isn’t that what we all want for our kids?
Points to Consider
First and foremost, think about your child’s personality and track record with money. Do they tend to be responsible decision makers with their money? If they’re really bad in this area, you may not want to lend the funds. A little tough love may help them more in the long run than a short-term loan. On the other hand, if they’re merely just inexperienced, a loan from you with terms similar to a bank would help them gain practical experience and discipline.
Think about the reason for the loan. Is it sensible or frivolous? A “hand up” or a “hand out”? Would it be more valuable to have a discussion about needs vs. wants or about immediate vs. delayed gratification?
Has the child attempted to borrow the funds from a traditional lender? If not, perhaps they should try. They may get a loan and begin establishing a credit-rating.
Consider the risks of the loan not being repaid, beyond not getting your money back. How will it affect your relationship with the child? With any of your other children? Will there be hurt feelings?
Take into consideration the amount of the loan. If it doesn’t get paid back, will the loss put you in a bad position? Will lending the money prevent you from being able to help any of your other children if they need assistance?
Evaluate the timing of the loan. Does the time frame work for you? Sometimes you don’t have to say no to your child, but you may have to say, “not now”. You’ll also need to consider the time frame you need or want the money to be repaid.
Think about starting small first. Offering to provide a portion of what the child is looking for will force them to become resourceful in putting together the remainder of the funds. Learning to be disciplined by saving more, or creatively earning more money will help them in the long run.
If your child is looking for money to start a business, consider taking a stake in the company rather than lending money. As a shareholder, you could take the loss on your investment if the business fails (perhaps useful from a tax perspective — again, check with an accountant). If the business goes well, and you want your money back, you can always sell your shares back to the child when the company has plenty of cash flow.
Guidelines for Lending
After taking all of that into consideration, and assuming you now want to go ahead with a loan, here are several guidelines you should follow:
— Only lend money you won’t miss if you don’t get it back (essentially money that otherwise would be considered a gift).
— Make sure your child is clear about the purpose of the loan. Don’t cut a cheque if you don’t know what the money’s for. Then follow up to make sure the proceeds were used for the purpose stated.
— Use real-world terms for the loan. The rate of interest, the time frame of the loan… all of these should reflect what you’d be dealing with if you borrowed the money from a bank. If you want to make things easier on your child, consider making flexible terms for them in the event of job loss, illness, etc. but be sure to talk about these things first, not when the situation arises.
If you feel guilty about earning interest off your child, you can always gift the interest back to them AFTER they’ve repaid the loan. You could also donate the money to a charity they support in their name, or take them on a trip. However you want to handle it after the loan is paid is up.
— If necessary, put conditions on the loan. For example, if your child has a track record of being poor with money, agree to lending the money only after they have successfully completed a course on money management.
— Put it in writing. Some advisors recommend getting a lawyer to formally draft a loan agreement. I think it would depend on the amount of money involved, but even for small amounts obtain a standard loan agreement form and fill it out with the specific terms. Make copies for both of you, signed, dated and witnessed by a third party for legitimacy.
— On the issue of transparency, there’s generally two camps: those who think that when you lend a child money, any other siblings should be made aware. Others feel that privacy between a parent and each child is paramount so no other siblings need be involved. I would suggest it depends on the dynamics of your family and also on the reasons for the loan, which may be extremely personal. Put some considerable thought into this before making a decision one way or the other.
— I would recommend you put a copy of the loan agreement with your will and let your executor know you’ve lent a child money. Then, if you should die prior to repayment, the loan can be subtracted from any inheritance the child would otherwise receive. This will eliminate any hard feelings from siblings during the estate settlement. Next time you update your will, you might wan to put in a blanket clause allowing the executor to make adjustments to distributions to account for any outstanding loans to any of your children.
Following these guidelines will help you face a situation when a child is looking for a loan and you’re not quite sure what to do. It’s not a light decision to make. Be sure to consider it carefully and don’t hesitate to get advice from any of your other financial advisors before going ahead.
