With tightening lending requirements and tough economic times, not to mention the generational phenomenon of helicopter parenting, we’ve been seeing more parents doing something they swore they’d never do—lending money to their children. For example, according to a recent survey, 20% of parents have already gifted, loaned, or co-signed a loan to help their children purchase a home and an additional 2/3s of parents indicated they would like to do so in the future. But is this really a good thing?
On the surface, the decision to lend money to your children may seem like a no-brainer. Helping someone else accomplish their financial goals can be highly rewarding, especially when the person you are helping is your child or another close family member. Unfortunately, the reality of family loans is much more stark. They can often become a lose-lose-lose proposition: bad for mom and dad, bad for their adult children, and bad for the economy.
Consider the following:
Parents who loan their children money typically fall into one of two categories:
1. The bank of first resort, for families where children feel entitled to lean on mom and dad when they need something rather than pursue avenues that might require more initiative and accountability. If mom and dad will give you a no-interest rate loan and won’t press you when you are late repaying the principal, then isn’t that a better, easier way to go than a financial institution which actually expects to be repaid, on time, with interest, per your agreement? Sounds like a great idea for the adult child, but is it really? Adult children who are given frequent loans from their parents are often much less successful than those who are forced to make it on their own and this entitlement from their parents may expand into ultimately tapping into governmental resources to support themselves. This is where family loans can have huge economic ripple effects, creating financial dependence in a society where financial independence is more critical than ever.
2. The bank of last resort, when a child’s credit or capacity to repay the loan is so poor that no other financial institution is willing to take the risk of providing them with a loan. If organizations in the business of evaluating credit risk turn your child down, then shouldn’t that be a cue to you that maybe the risk is too high for you as well? This is particularly true if you are doing so, as most parents do, without interest— potentially compromising future goals like retirement. Ironically, parents in this situation often end up having to financially burden their children later in life due to helping them too much at the cost of their own financial security.
Example: a $10,000 loan to a child when the parent is 50 to be paid back in 5 years but never repaid
Cost to retirement savings at age 65: $31,722 (at an 8% return)
This is not a win for anyone involved. In this case, family loans can increase the chance of the parents becoming financial dependents as well.
All that said, there are some exceptions where family loans can work. As financial educators who regularly counsel parents on this topic, we do encounter situations where family loans are a good idea and where they end up paying off for everyone involved. Almost invariably, these situations have the following characteristics:
1. The child has been financially independent and responsible for a while and needs the loan due to unforeseen circumstances, like a major health crisis, or for an opportunity that demonstrates true resource and initiative, like starting a new business based on expertise they have demonstrated throughout the course of their careers. (In the case of starting a business, we typically recommend parents actually offer loans that can convert into equity with a personal guarantee from their children to repay the loan even if the business goes bust. This allows parents to get the opportunity to convert their loan into shares of the company if it becomes a success but also protects their downside).
2. The parents are themselves financially secure, the loan is a very small percentage of their overall wealth, and they will not compromise their retirement or any other financial goals if the child defaults.
3. Both parties are willing to look at this as a business arrangement, sign an agreement on terms, and separate the financial aspects of their relationship from the personal ones. This is easier said than done. It requires maturity on both sides and a willingness to formalize an agreement. We also encourage parents to charge interest as it provides accountability and also protects the parent from opportunity loss since they are not able to invest that money elsewhere for the duration of the loan.
Sometimes it is hard to tell which camp you are in because when it comes to our own children – adult or not – emotion clouds our judgment. So if you have any thoughts at all that a loan might be a bad idea, it probably is. On the other hand, if the loan makes financial sense, it can be a great win/win proposition. With interest rates at the bank being so low right now, you may be better off loaning to your kids – with a signed agreement of course.
Liz Davidson is CEO of Financial Finesse, the leading provider of unbiased financial education for employers nationwide, delivered by on-staff Certified Financial Planner™ professionals. For additional financial tips and insights, follow Financial Finesse on Twitter and become a fan on Facebook.
