Act 1, Scene 3 of Hamlet instructs us, “Neither a borrower nor a lender be.” This advice has a lot of good intentions when it comes to family and friends because no one wants to be in a situation of chasing down a friend for money they have not paid back.
But Shakespeare didn’t have to purchase a home with a 30-year mortgage loan.
In some circumstances, a loan to an adult child might be a good solution for both the parent and their child. Check out the benefits and mistakes to avoid below, along with some tips for navigating this sensitive situation.
Benefits of Lending to Your Adult Child
As a parent, you naturally want to help your kids where possible. So, when is providing them with a significant loan a good idea? Consider that:
- A well-conceived loan to a child might enable them to borrow when no commercial bank would qualify them for a loan.
- The interest rate might be more manageable for your child.
- Your child will still learn the discipline of loan repayment—and may even surprise you with early repayment!
- In some circumstances, if a mortgage loan is structured correctly, the child may be able to deduct the interest on their tax return.
- If an investment account is helping support the repayment, the child can benefit from the advice of an objective third party.
By lending money to your adult child, you can help them reach their goals. Plus, they’ll learn financial responsibility because you’re not simply giving them a handout.
Common Mistakes to Avoid
While loaning money to your kids allows for more flexibility and essential lessons, it can also backfire if you don’t start with a clear plan and expectations. Take note of these common missteps and how to avoid them if you do decide to lend your adult child money:
- Many parents fail to treat the loan as a bank would. But borrowing money is a serious business, so treat it that way. Know exactly what the loan is for and outline these details in a legal agreement.
- Your child might treat the loan as a gift—after all, they’ve likely received gifts from you their whole life! Make it clear that this is NOT a gift. Establish a repayment schedule that works for you and your child, addressing their ability to maintain these payments.
- Speaking of repayment, parents who lend money to their kids often forget to set up automatic payments. But doing so ensures your child doesn’t fall behind, allowing them to work it into their monthly budget and preventing issues and tension.
- Avoid giving your child too low of an interest rate or none at all. Doing so could trigger gift tax rules. The IRS sets applicable federal rates (AFRs) monthly, and loans with interest rates below the AFRs may be considered a below-market loan. Learn about AFRs. With regard to gift and income taxation, consult with your tax advisor.
Support Your Child While Setting Boundaries
There are plenty of scenarios where Shakespeare’s advice should be taken seriously. But if your adult child has a reasonable need for a loan, it’s possible to both support them and protect yourself.
Think of yourself as the bank, making it clear to your child that it is a loan they must repay. Your terms can and should also include what will happen if they default on the loan. Setting it up properly from Day 1 will encourage your child to take it seriously.
Do you need guidance in setting up a solid, detailed loan for your child? Contact Carlson Investments today to learn how we can help!
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