Law School Discussion

Borrowing from the bank of Mom & Dad

Borrowing from the bank of Mom & Dad
« on: May 03, 2006, 12:30:58 PM »
Interesting article for those of you thinking about doing this:

Gen-X Investor
Borrowing from 'the Bank of Mom and Dad': Best to get terms of intra-family loans down on paper
By Boyd Erman
Financial Post
29 April 2006
National Post

There's a lot of talk these days about the growing number of adult children borrowing from the so-called "Bank of Mom and Dad."

If this borrowing takes the form of loans, and not gifts, those loans often look a lot like the ones some chief executives get from their companies -- low interest and easily forgiven. But that kind of wealth transfer, with few or no strings attached, raises hackles among those Horatio Alger-loving parents who believe kids should make it on their own.

So, how to help the kids without resorting to out-and-out charity? The answer may lie in an intra-family loan in which mom and dad act like a real bank -- the kind that charges interest.

Everybody can win with this type of loan: Parents and their offspring can split the difference between the interest rate that parents are getting on their savings and the higher rates that their kids must pay the banks to borrow.

The rate on a five-year GIC stands at about 4.7%. Many parents are seeking ways to eke out a little more income, while the prime rate -- the best many young adults can hope to get on a loan -- is 5.75%. Split the difference and there's no downside, right?

Except for the fact that, done wrong, an intra-family loan "can result in unintended and untenable financial hardship for older adults, and strain family relationships to the breaking point, even where all parties have the best of intentions." Those words of doom and gloom are brought to you by the British Columbia Law Institute, which took a look at the issue.

To do it right, you have to treat borrowing from the Bank of Mom and Dad just like getting a loan from any other financial institution: There are rules, deadlines and consequences for missed payments.

The key is in the paperwork. A proper contract will set out the terms of any loan, such as interest rate, payment frequency and punishments for default. The main tax consideration for a private loan is that the lender has to declare any interest income, but the paperwork will help to prove to tax authorities, if necessary, that the money has been loaned and not given.

Contracts can also outline the punishments for missing a payment, which must be negotiated ahead of time. Parents likely aren't looking to ruin their kids' credit, or their kneecaps, but there are ways to make things painful (Try this: "You're out of the will, Sonny!").

A contract can also help avoid sticky family situations. Should the parents pass on while the loan is outstanding, a written record will provide the estate with evidence of the loan so that the kid who owes the money doesn't end up with an outsized share of the inheritance.

In the United States, loans from friends and family are so prevalent -- an estimated 10 million people have them -- that a company called CircleLending has carved a niche as a middleman for lending and even mortgages. The company will act as a third party in a parent-to-child loan, providing standardized contracts and services such as direct-debit transfers from the kid's bank account to the parents'. The company boasts that its services lower the default rate on intra-personal loans to less than 5% from 14% for more casually set up private loans.

In Canada, no similar service exists on a large scale. But would-be Banks of Mom and Dad can draw on basic contracts that can be customized to reflect the terms of the loan. The B.C. Law Institute's study, available at Financial_Arrangements_CP.pdf, provides a model document, and standard contract forms are also available in some stationery and bookstores.