Loaning Money to Your Child

What if an advance on an allowance just isn't enough to help your child out? For example, what if your teenager wants the latest electronic game platform that costs a few hundred dollars and he doesn't want to wait until he gets his birthday money from Grandma? Should you become a banker and loan the money to your child?

You have three choices:

• You can say no and refuse to help. Maybe you're saying no because you don't want your child to have the money. Or, maybe you just can't afford to help. Either way, it's an important lesson for your child to learn that, as the Rolling Stones have said, “You can't always get what you want.”
• You can give the money that's wanted without asking for any repayment. Here you're making a gift, not a loan. You might want to label the gift as a reward for something—making the honor roll or getting the lead in the school play.
• You can make the loan and set conditions. For example, you can insist on interest or make the loan interest-free.

When to Be (or Not to Be) a Banker

It's not easy to say no to your child. But when you're asked to lend her money, when is it okay to say yes? And when should you say no?

Say yes in these cases:

• The money is needed for a good reason. For example, your child needs help buying a car that she can afford to keep up. Or, her savings won't cover her college expenses and she prefers to borrow the money rather than get it as a gift from you.
• You believe your child is responsible enough and able to repay the loan. If she has an after-school job and has repaid a loan from you before, you can be pretty comfortable with the situation. But if she's always asking for more, there's something wrong with this picture. Go back to Teaching Your Child About Money Management, Savvy Shopping Strategies for Kids, and Setting Up a Budget for Your Child.
• You can afford to make the loan. Don't let guilt drive you to financial problems. Just because a child asks for a loan doesn't mean that a parent is required to make it. Doing so might force a parent into debt of her own, which doesn't make much sense.

Before lending any large amounts of money to your child, consider the impact that such a loan might have on your other kids. Are you depriving them of something to make the loan to one child? Are they going to want (and expect) the same treatment? Is the loan going to cause jealousy among your children? It's a good idea to address these questions before you agree to make a large loan.

Say no in these cases:

• You disapprove of your child's use of the money. If your 16-year-old wants to buy a motorcycle and you're horrified at the prospect, just say no. This is really more a question about the motorcycle than about making a loan, but you can quickly end the possibility that he'll get a motorcycle and then later discuss your feelings about his riding a motorcycle.
• Your child is becoming a chronic borrower. If he always seems to be in need of cash and constantly asks you for loans, it's time to say no and have him brush up on his budget-making or spending skills. Maybe his spending column adds up to more than his allowance or earnings for each period. Or, maybe he makes a great budget but just doesn't stick to it.
• You can't afford to make the loan. You may be on a strict budget that doesn't have room for loans to your child. Don't feel guilty. That's just a fact of life that your child will have to learn.
• You'd create problems within the family. Your other children may resent your constant financial underwriting for one child, especially if it comes at the expense of the others. In one family, the mother was always bailing out the baby from financial trouble. Over the years, his siblings grew to resent him for this favoritism.

Make It Formal

When kids get a little older and want more than just an advance of $5 or $20, you may not want to keep things casual. A big advance on an allowance or a loan to buy a big-ticket item should be treated formally.

• Put it in writing. Make your child sign statement about what has been loaned to him. This statement is really a type of promissory note in which he agrees to repay the amount stated.
• Set a repayment schedule. You can leave the time for repayment open-ended or can make the loan payable on demand when you say so. It's probably a better idea to set a timetable for repaying the loan, though, so your child doesn't overlook this obligation. Don't leave the debt to be repaid “when he has the money.” Require him to make small repayments (or to forgo a portion of his allowance) on certain dates.

  If your child is borrowing from you to pay college expenses, you might not want to start repayment until after graduation. By then, he'll be working full-time.

• Charge interest. If the loan is going to run for more than just a few weeks, it can be a good learning experience to charge interest. You won't get rich on the interest, but your child will see the real cost of borrowing. How much should you charge? You don't want to make the interest too low, because it's not realistic. Nor do you want to make it too high. It's probably a good idea to use the commercial rate being charged on a personal loan in your area. To find out the going rate, just call your neighborhood bank or look at ads in the local newspaper. Remember that the purpose of the interest isn't to create an income for you, but to teach a lesson to your child.

Keep in mind that the tax law may treat you as if you had charged interest even if you make the loan interest-free. Under so-called imputed interest rules, a lender is treated as receiving interest that he effectively waived by not charging.

If the lender makes a low-interest loan, he's treated as receiving the difference between the amount charged and what the government thinks should have been charged. The amount of interest is based on applicable federal interest rate (AFR) at the time the loan is made. That rate changes every month, and there are different rates for loans of three years or less (short-term), loans of three to nine years (mid-term), and loans over nine years or more (long-term). However, no interest is imputed to the lender in two situations:

• $10,000 gift loan. If the amount of loans between the lender and borrower—you and your child—isn't more than $10,000, there's no imputed interest as long as the money isn't used to buy income-producing assets (such as stocks or CDs).
• $100,000 gift loan. If the amount of loans between you and your child is no more than $100,000, there's no imputed interest as long as your child's net investment income isn't more than $1,000. For example, if you make an interest-free loan of $25,000 that your child uses for college, there's no imputed interest to you as long as your child's interest, dividends, and capital gains do not exceed $1,000.

Excerpted from The Complete Idiot's Guide to Money-Smart Kids © 1999 by Barbara Weltman. All rights reserved including the right of reproduction in whole or in part in any form. Used by arrangement with Alpha Books, a member of Penguin Group (USA) Inc.

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