Your grandson needs help with the down payment on his first home purchase. Your daughter needs help starting her own business. Your godson needs all the help he can get! You are more than happy to help your loved ones out with their cash-hungry endeavors, but have already exceeded their individual annual tax-free gifting threshold of $13,000. Not to worry, today’s low interest rates make it a great time for families to transfer wealth and reduce estate taxes through intra-family loans.
According to Bankrate.com, the 30 year fixed mortgage average of 4.19% (Tuesday, 8/30/2011) is at a 50 year low. Although these low interest rates may be disheartening for those who want to invest in fixed income investments, they are advantageous for those that want to borrow – even better if the borrower has a family that can lend. Here’s how it works; every month two things happen, the Treasury issues new securities and the IRS publishes new Applicable Federal Rates (AFRs) that are based on the rates of prior-month Treasury issues. As Treasury issues have been extremely low for quite some time, so have AFRs. Happily, AFRs are considered the minimum rates that family members can charge for intra-family loans.
This time of historically low AFRs presents families two basic opportunities:
- Wealth shifting through interest rate arbitrage.
For example, Sam is about to spend the next three years self-producing his first documentary on urban farming. Knowing that Sam could use some extra cash, Grandma Rose decides to loan Sam $20,000 on a three year promissory note with a 0.26% interest rate (which is the annual AFR for September 2011 for loans with terms between one and three years) so that he could reinvest the funds at a higher interest rate and keep the difference. Although Sam must pay Grandma Rose $52 each year and ultimately repay the $20,000 after three years, Sam nets $248 each year by putting the investing the funds in a three year certificate of deposit (CD) with a 1.5% interest rate. By using AFRs, Grandma Rose shifted wealth from herself to Sam by giving him the opportunity for investment returns.
- Aiding someone in a financial bind.
For example, Rick is a gainfully employed tennis instructor, but has managed to accumulate $20,000 of high interest credit card debt. New consumer protection disclosures on his credit card show that by paying only the minimum recommended payment on his 20% annual rate card, he’ll be paying for 415 months and his total interest will be $32,727 – far more than what he initially borrowed. Concerned, Rick goes to Dad for some advice. Dad determines that his son could pay off the debt in 60 months by paying this month’s minimum payment of $533.33 every month. Since Dad has an extra $30,000 in his money market account that he had planned to invest in a CD with a rate of 1.75% per year, he offers to pay off Rick’s credit card with a $20,000 loan that his son can repay at a more manageable $450 per month. At a 1.63% rate (which is the annual AFR in September 2011 for loans with terms between three and nine years), he can repay the $20,000 in 46 months. He’ll save over $11,000 of interest compared to paying his credit card company $533 for 60 months and Dad will get a higher interest rate than what he would have gotten from a CD. Another plus to this strategy is that Dad can make strings attached to this loan, like requiring Rick to engage in financial counseling so that he learn to live within his means.
As illustrated above, intra-family loan opportunities are not only for the ultra-wealthy. In neither case was the amount loaned large. However, more complex transactions involving larger loan amounts can transfer more wealth or provide greater financial assistance. The financial reward in these intra-family transactions is largely for the borrower. Still, as with any investment, there is risk of loss for the lender when the borrower won’t or can’t repay the loan. Just like any investment, these transactions should be evaluated carefully to assess the risk they present in the lender’s portfolio.