Tapping the Family Bank?
P2C News - Monthly update for families building wealth 12 January 2016

Rather than turning to a bank, families in large numbers are setting up their own loans with grandparents or parents becoming the lender. 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 can gain access to interest rates that are lower than commercial rates and with better terms than a bank might offer.

A lender offering a parent-to-child loan product, such as La Trobe Financial, allows the lender to set an interest rate with a minimum of CPI (currently at 2.6%) + 0.5% inclusive. These interest payments can be fixed or variable with movements tied to the RBA cash rate set quarterly. In effect, a parent could lend at a lower rate or alternatively refinance their own mortgage and cover the interest by an increased charge to their child.

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.

There are numerous reasons for making sure that a loan is fully documented and administered by an independent third-party, not least because your home is not used as security, your credit rating is not at risk and your children can still qualify for grants and concessions. The flexibility of such a loan even means both sets of parents can contribute to the loan rather than all the weight resting on one party.

Going down the traditional route of lending money to your child directly or providing a bank guarantee can mean, in the worst case scenario, you could end up losing your home or compromising access to your retirement funds. Signing on as a co-buyer might also seem like a good idea, but your child could miss out on the First Home Owner Grant or stamp duty concessions and investing in property may be less tax effective for you than leaving that money in superannuation.

An article (“Lenders’ Blind Trust and Borrowers’ Blind Spots: A Description Investigation of Personal Loans”) published in the Journal of Economic Psychology focussed 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 co-author 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 have not been paid off and were overdue — resulted in wide-ranging negative repercussions. Again, the self-serving bias came into play: “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.”

Professor Lowenstein’s advice to would-be lenders and borrowers is to make sure the loan is well-documented.

Cory Bannister, Chief Lending Officer at La Trobe Financial says “at present 35% of all loans by La Trobe Financial have financial input from parents”.

“What is attractive about loans is that they are relatively simple,” he 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. 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 parents and families to bear in mind when discussing intra-family loans:

  • The loan must be well-documented. Disagreements over loan terms can strain relationships and engender ill will.
  • The lender should make sure the borrower is able to repay the loan and the loan meets the borrower’s requirements and objectives.
  • Don’t play favourites. The family dynamic works best when parents make similar loans to other children or family members. Favouring one person can rouse long-simmering resentments among those who don’t receive loans.
Best regards,

Martin Barry
Vice President,
Chief Wealth Management Officer

     
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La Trobe Financial is one of Australia's leading independent credit specialist Fund Managers. Its business includes residential mortgages, commercial mortgages, and investment services operating one of Australia's largest Credit Funds under AFSL 222213. It employs over 150 staff and has managed over AUD$10 Billion covering over 100,000 investment grade assets since inception in 1952.

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