The Bank of Mom and Dad

Lending money to your adult children can be a smart move given today’s low rates, says Jonathan M. Bergman, CFP, vice president of Palisades Hudson Financial Group.

Instead of a son or daughter borrowing money from a bank at a high rate while the parents earn very little, this cuts out the middleman.

“The bank’s profit instead stays in the family,” Bergman says. “It’s the perfect time to consider an intra-family loan.”

Family loans can be used for a variety of purposes. They can help a child launch a new business venture, invest in a securities portfolio with a higher expected return or return to school. The child gets a lower rate than he or she would from a commercial lender, and the parents do better than they would in a bank.

Another savvy idea is to refinance existing family loans or third-party debt with family loans since today’s rates are lower.

Helping children buy a home is another option.

“The Bank of Mom and Dad can lend the money to the child at a low rate, using the home as collateral,” he says. “Junior can borrow 100% of the purchase price without any need for mortgage insurance.”

Have a lawyer draw up a formal mortgage and promissory note, Bergman advises. The child should obtain adequate homeowner’s insurance, just as a bank would require.

Family loans also can help reduce federal and state estate taxes, Bergman says. Although only estates over $5 million for individuals or $10 million for couples pay federal estate tax, many states levy estate or inheritance taxes on much smaller amounts. In New York and Massachusetts, for instance, the estate tax kicks in at $1 million.

“Many people who don’t have a federal estate-tax problem are surprised to learn they will be subject to state estate taxes,” Bergman says. “And today’s big federal estate-tax exemption may be a temporary reprieve. It’s scheduled to go back to $1 million in 2013.”

The idea of the loan is to get the appreciation out of the estate.

“Instead of paying gift or estate taxes on your future appreciation, with the loan, the excess return goes directly to the child or a trust for the child’s benefit,” Bergman says.

However, you can’t give your child too low a rate, or the IRS will consider it a gift. The Applicable Federal Rate (minimum rate), for November 2011 is a tiny 0.19% percent for terms less than three years, 1.20 percent for a three- to nine-year loan, and 2.64% percent for more than nine years.

Let’s say Mr. and Mrs. Welloff, who are in their early 60s, lend their daughter, Jane, 25, $100,000, and give her a nine-year loan at 1.20%. As part of the deal, Jane invests in a diversified portfolio of stocks, bonds and REITs that produces an annual average return of 7% annually over nine years. After paying $1,200 in interest payments each year for nine years, plus repaying the $100,000 principal at the end of the ninth year, Jane would have $69,472 in her account.

If the parents don’t need the money back, the agreement can be renewed. Jane will continue to see her nest egg grow — instead of having assets grow in her parents’ estate and boosting future estate taxes.

“Family loans work well when interest rates are low and expected appreciation on investments is higher,” Bergman says.

Today’s low-rate environment opens a large spread between what the child is required to pay in interest and what can be earned with the borrowed money. This maximizes the amount that is transferred from the older generation to the younger generation tax-free.

“Everyone wins,” Bergman says.