Time to Tap the Family Bank? Benefits and Pitfalls of Intra-Family Loans
We’ve all heard stories of families and friendships torn asunder because of disagreements over money. So my curiosity was piqued when a press release about new research on the pitfalls of personal loans landed in my inbox. Jason Zweig, columnist at the Wall Street Journal, also tweeted the report, describing it as “the gnarly psychology of lending money to people you know.” Gnarly, indeed, given the fact that intra-family loans are increasingly popular among wealthy clients in this low interest rate environment. Some families are even turning to the “family bank” to help a child or grandchild pay for college. According to a recent article in the Wall Street Journal, “In some cases, rather than turning to a bank, families are setting up their own loans with grandparents or parents becoming the lender.” (See “Borrowing From Family to Pay for College.”)
If properly structured and well documented, these loans can be a smart estate planning tool: Lenders reduce their taxable interest income (thus removing appreciation from their estates), while borrowers gain access to interest rates that are lower than commercial rates and with better terms than a bank might offer. (The Internal Revenue Service, or IRS, allows borrowers who are related to pay a very attractive, low interest rate, known as the Applicable Federal Rate, or AFR. This is the minimum interest rate that may be charged on intra-family loans. The AFR can be found on the IRS website.)
Another advantage of these transactions is that the total interest expense over the life of the loan stays within the family instead of being paid to a bank. (See the section “Intra-Family Lending Offers Potential Tax-Free Transfer While Lending a Hand” from Fiduciary Trust International.)
But first, a quick recap of the findings recently detailed in “Lenders’ Blind Trust and Borrowers’ Blind Spots: A Descriptive Investigation of Personal Loans” published in the Journal of Economic Psychology.
The researchers focused on personal loans between peers, but the two main findings are just as relevant for understanding the dynamics of intra-family loans.
First, borrowers are subject to a wide range of self-serving biases when it comes to loans. George Loewenstein, professor of economics and psychology at Carnegie Mellon University and a coauthor of the study, explained that the self-serving bias is “the tendency to confuse what is in your interests with what is fair, and the belief that what is fair is what happens to be in your interests.”
So, for example, borrowers are more likely to believe that the loan was initiated by the lender, that the loan had been paid off as agreed upon, and to report that a loan that they were delinquent in repaying was really more of a gift than a loan. These differing recollections lead to misunderstanding between lenders and borrowers.
Second, delinquent loans — loans that had not been paid off and were overdue — resulted in wide-ranging negative repercussions. Again, the self-serving bias came into play. According to the press release, “Borrowers predicted that they would eventually pay off such loans, while lenders predicted they would never be paid. And lenders of delinquent loans reported lower feelings of closeness to, and trust in, the borrowers, and also reported that delinquent borrowers were avoiding encounters with them. Borrowers, for their part, seemed to be blithely unaware of the negative feelings aroused in lenders, and, on their own part, did not report any similar change in feelings toward the lenders.” The part about lenders being “blithely unaware” is what the researchers called “blind spots.”
Lowenstein’s advice to would-be lenders and borrowers is to make sure the loan is well-documented. To that end, the IRS publishes monthly AFRs. In recent months, the rates have fallen to historic lows. In September, for example, the AFR is 0.21% for loans of three years or less, 0.84% for loans of more than three but less than nine years, and 2.18% for loans of a longer duration.
Gail E. Cohen, vice chairman and general trust counsel at Fiduciary Trust International, said she has seen a lot of interest recently in intra-family loans.
“What is attractive about loans is that they are relatively simple,” she says. “The concept is something that most people understand — most people have borrowed at some point in their lives, and so they understand the concept of a loan, interest, and repayment. When you try to describe a grantor retained annuity trust (GRAT) to a client, this is not something they have run across before. The loan concept is easy and relatively straight forward and that is one of the reasons why it is popular.”
That said, here are some points for financial advisers to keep in mind when discussing intra-family loans with clients:
- The loan must be well-documented. Cohen said it very important that the promissory note specify the interest rate (it cannot be lower than the AFR), the due date, and the payment schedule. Disagreements over loan terms can strain relationships and engender ill will. And remember that even a well-structured, meticulously documented transaction can backfire.
- Whenever possible, the lender should also ask for collateral.
- The lender should make sure the borrower is able to repay the loan.
- Discuss the tax implications. Lenders should carefully consider “forgiving” interest and principal. Cohen pointed out that loan forgiveness “absolutely is a gift” in the eyes of the IRS, and so it’s important to keep in mind the annual gift tax exclusion (currently $13,000 per person). Also, the lender needs to be aware that the interest received is taxable.
- Don’t play favorites. Cohen said the family dynamic works best when parents make similar loans to other children or family members. Favoring one person can rouse long-simmering resentments among those who don’t receive loans.
For more on this topic, see “Intra-Family Loans: Common Hazards and 10 Steps to Avoid Them” from Bessemer Trust and “Low Interest Rates Makes Intra-family Loans Appealing” in the Journal of Financial Planning.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.