The Federal Reserve has raised interest rates dramatically since March of 2022, which has created a more difficult environment for younger people to qualify for bank loans. With these high rates, banks have tightened lending standards, and a number of clients have asked; is this an opportune time to make loans to their children or grandchildren?
Many families handle the process in informal oral agreements, but I urge families to document such loans in written contracts, just as a bank would. This can also make it easier for families to comply with tax rules. For the borrowers, often adult children, the advantages of these loans may include access to below-market interest rates and easier repayment terms than a bank might offer.
If the family member, the lender, should die before the loan is paid off, the executor will be able to account for the outstanding debt to the estate.
Lending to family members, such as sons, daughters, and grandchildren can return better interest rates and streams of income that standard investments cannot provide. Still, family loans are hardly risk-free. The default rates on loans at least partially funded by a relative or friend are typically 20% to 40% below the national average.
Certainly, I discourage people from taking obvious risks, such as extending loans to children who have difficulty managing finances. You want to make sure that by making a loan you are not enabling someone to amass even more debt. In such situations, parents need to think about these loans as gifts, and consider whether they can afford not to be paid back.
Loan interest rates are considerably higher, and the odds of getting rejected by commercial lenders have increased. If you have an adult child, or grandchild who wants to buy a home or start a business, it’s a great time to help, but make sure it is designed carefully and with rules, otherwise, it is a plan for failure.
Be Educated! Be Proactive!