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Should parents lend money to a child to help pay off her student loans? The child would then repay the debt to their parents at a lower interest rate. What are the pros and cons of parents lending money to their children? How should such a loan be structured? And what are the other ways to help your kids pay down student loan debt?
Disadvantages of Lending Money to Children
It is never a good idea to lend money to a family member. If the family member were to default on the loan, it will lead to awkward holiday dinner conversations. It can also lead to resentment of the lender by the borrower. When was the last time you heard a borrower say that they loved their lender?
If a child borrows money from their parents, the parents might start criticizing financial decisions by the child. They might do that anyway, even if the child doesn’t borrow money from them, but it is more likely to occur when a family loan is involved.
Some parents may hesitate to have a tough talk with their child if the child misses a payment on the family loan. Emotions and business should never mix.
If the parents decide to lend the money anyway, they should assume that the debt might not be repaid. Even if the child wants to repay the debt, they might lose their job and be unable to repay the debt. So, they shouldn’t do this if they are counting on the money for their retirement.
Using a home equity loan instead of savings to fund the loan payoff would be even worse. If the child doesn’t repay the debt, the parents will nevertheless still have to repay the home equity loan. If they default on the home equity loan, they could lose their home. If the child defaults on her student loan, the lender cannot repossess her education.
You should never lend money when you owe money, especially if your debt charges a higher interest rate.
Family Loans are Not Qualified Education Loans
The definition of qualified education loan at 26 USC 221(d)(1) excludes any indebtedness that is owed to a relative, such as a sibling, spouse, ancestor or lineal descendant.
So, a loan from the borrower’s parents will not be eligible for the student loan interest deduction even if it refinances student loan debt.
Qualified education loans generally cannot be discharged in bankruptcy. A loan from the borrower’s parents can be discharged in bankruptcy.
Family Loans Don’t Build Good Credit
Family loans are not reported to the credit reporting agencies. As a result, the child’s performance in repaying the debt will not help them build a good credit history. It also won’t hurt their credit if they are late with payments or default on the debt.
Beware of Informal Loan Agreements
Sometimes parents make a loan to a child on an informal basis, without a signed promissory note. This is a big mistake. Without a signed promissory note, the child can assert that the money was a gift, not a loan. Loans that don’t have written promissory notes are less likely to be repaid. Having a written agreement prevents future disagreements.
The loan should be documented with a signed promissory note that was drafted by an attorney, so that there is no question about the money being a debt and not a gift.
The promissory note should specify the interest rate and repayment terms, as well as any incentives for repaying the debt more quickly. The promissory note should also specify penalties for late payments.
Tax Consequences of Family Loans
If the parents do not document the loan with a promissory note, the IRS can consider the full amount of the loan as a gift, potentially leading to gift taxes if the loan amount is large enough.
The loan should charge at least the minimum interest rate required by the IRS. The applicable federal rate is typically about a percentage point below market rates. The parents will need to report the interest they receive on the loan as income on their income tax returns. If the parents don’t charge interest, the IRS will assume that they earned the amount of interest that they should have charged. The IRS will also treat the interest as a gift from the parents to the child, counting it against the annual gift tax exclusion.
Alternatives to Lending Money to Children
Instead of lending money to children, parents should consider a few alternatives:
- Encourage the child to use an income-driven repayment plan for their federal student loans. This will base the loan payments on the child’s income, as opposed to the amount they owe.
- Help the child qualify for a refinance by helping them make the payments on their student loans. This is less risky than cosigning the loan. Keep in mind that refinancing federal loans into private loans means a loss in many benefits – income-driven repayment, any federal loan forgiveness programs, generous deferment options, death and disability discharge, subsidized loans, and more. If you decide refinancing is right for you, we have a list of the best lenders to refinance. Also, Splash Financial is a student loan refinance marketplace that matches you with a lender with a low interest rate.
- Download the ChangEd App. You link your bank account and credit cards, along with your child’s student loans. Every purchase you make is rounded up and is then applied to their debt. Learn how it works.
- Ask the child to share their loan statements with the parents, so the parents can know when their child is getting into financial difficulty.
- Give the child a gift to help them repay the debt. This could be a lump sum amount or monthly or annual installments. For example, the parents could provide their child with a dollar-for-dollar match for their payments on their student loans. If the gift is given in installments as opposed to a lump sum, it might avoid gift taxes by staying under the annual gift tax exclusion. Giving a gift avoids the negative consequences of a family loan that is not repaid.
- Cosigning a private student loan or refinance for the child should be a last resort. Cosigning a loan can help the child qualify for a lower interest rate. But, cosigning a loan has some of the same issues as a family loan, since the parents will be stuck repaying the debt if the child is unable or unwilling to repay the loan. If the child is late with a payment, the late payment will hurt the credit history of both child and parent.
- If you do decide to cosign a refinance, you may want to opt for a lender that offers a cosigner release. College Ave, Commonbond, LendKey, and PNC Bank are just a handful of lenders that offer cosigner release.
At Savingforcollege.com, our goal is to help you make smart decisions about saving and paying for education. Some of the products featured in this article are from our partners, but this doesn’t influence our evaluations. Our opinions are our own.
