How to Structure a Family Loan

In this video, we’re going to discuss how to structure a family loan with a rising interest rate environment. So Matt, one topic that we’re working clients through right now is how to structure a family loan, particularly with regards to a home purchase.

So do you mind walking us through some pros and cons for this? Yeah, absolutely. So with a lot of our clients that have kids that have just graduated college or potentially early stage of their career that are getting married and looking to buy their first house and evaluating how to best structure a legacy plan.

Do you wait till you pass to give your money kids? Or do you start that process or that help process while they’re still living? We’d recommend typically a mix between the two just so you can start transferring the values and disciplines that made you successful to your kids is such a much more important concept and tool than the money itself.

So one way that avoids gifting limits so for example, right now the gifting limit is a little bit above $12 million that you can give anybody tax free while you’re living or when you pass. And anything above this would get taxed at a 40% federal rate and would be applicable to any state taxes, depending on the state inheritance tax, that may or may not apply.

So one way around this, specifically when a child is buying a house, is to structure a family loan. So for example, if your child is buying a half a million dollar house and they go to a bank right now, most likely they would need some kind of down payment and there’d be closing cost and there would be an interest rate.

Right now, recording this video, in late April of 2022, interest rates have gone up to 30 year average. Right now for a fixed is about 5%. A year ago, we saw clients getting 30 year fixed for less than 3%.

So pretty dramatic rise in interest rates and the cost it would be for your child to be a homeowner. So how to structure a family loan? Give your child the money to purchase the house. Let’s say that half a million dollars gets transferred to them because it’s a family loan and an agreement is signed that is not a gift, that does not affect your lifetime exemption.

And your child has now avoided the fees and closing costs that a bank would impose on them. They’ve avoided having to have a large down payment. They are now a much more attractive buyer because the buyer, they’re a cash buyer in the eyes of the current homeowner.

This now gets structured based upon the federal rates, which in April of 2022 are 2.25% for a long term rate. And so now your child has avoided fees and they’ve gotten less than half of the current interest rate that a bank would charge them, which would be above 5%.

You can now charge them 2.25%. And just like a payment to a bank, they would make the monthly payment to you. There’d be an amortization schedule that we would create. You can agree to. They could pay off early if they want, they could just make the minimum payments over the 30 years.

But the transaction from them to you is tax free because it’s a loan. The transaction from them back to you, the principal is tax free. The interest on the amortization table would show up as ordinary income back to you.

This creates a very good dynamic for starting to have financial planning conversations, teaching your kids the responsibility of handling money, how banks work, how wealth transfer works, et cetera. It can be a tremendous way to help your kids in a way that’s not hurting them by just gifting it and them still having a payment, still having to stay motivated in their careers, and also, by the same token, helping them avoid half of the interest that they would otherwise pay to a bank.

We welcome any questions on this and happy to help you structure a family loan to help your kids and also teach them financial literacy and best practices.