How To Avoid High Interest Rates With The Bank Of Grandma

Forbes

Kelly Phillips Erb, a senior writer for Forbes, joins ‘Forbes Talks’ to discuss avoiding high interest rates using intrafamily loans.  0:00 Introduction  0:24 What Exactly Is Grandma's Bank? 1:41 Inter-family Loans Explained 3:33 Potential Risks Lenders Face 4:49 Always Have Paperwork Even With Family Members 5:40 Kelly Advices Balance And Boundaries In All Things 8:03 How Can Inter-family Loans Help The Middle Class?

Transcript

00:00 Hi everyone, I'm Rosemary Miller here with Kelly Phillips Erb, a senior writer here at

00:07 Forbes, here to tell us how to beat high interest rates with the Bank of Grandma.

00:13 Thank you so much for joining me today, Kelly.

00:15 Thank you for having me.

00:16 Kelly, I absolutely love that headline.

00:19 Those are your words, Bank of Grandma.

00:21 Could you tell us what do you mean by that?

00:24 So I think a lot of us think that when we are looking to borrow money, we're going to

00:28 hit traditional sources, right?

00:30 So we're going to go to our bank, we're going to consider borrowing from maybe retirement

00:34 accounts or other accounts that we have that may be a little off limits, but you know,

00:39 we're going to rate them because we need money.

00:41 But a lot of times we don't think about the fact that there may be another source of wealth

00:45 that's available to us and that could be grandma or your parents or you know, your favorite

00:50 uncle.

00:51 It is often the case that some older folks have access to liquid assets more than younger

00:58 folks.

00:59 And one of the reasons that we tend to have our things tied up in addition to younger

01:05 people maybe just being right out of, you know, in the job market and having some high

01:10 loans, maybe college loans, but a house, for example, tends to be the most significant

01:16 asset that person will enjoy in their lifetime.

01:19 And early on when it is mostly owned by the bank, it's highly illiquid.

01:23 So once you've been paying into it for a while, you might have more liquid assets.

01:28 So one of the ways that, you know, younger people can look to benefit from, and it tends

01:34 to be younger people benefiting from older people, although I shouldn't say that as a

01:37 full stop because it may be that grandma needs to borrow from you, right?

01:41 Your company took off and you're doing really well.

01:46 But inter-family loans are a way that folks can loan money to people who need it and assuming

01:54 that they have, again, they're comfortable and they have access to those assets, but

01:58 they can loan money to other family members that may need it at favorable interest rates.

02:04 And we all know that interest rates are pretty high right now, right?

02:06 So we're looking at mortgages, credit cards, and student loan repayments at interest rates

02:13 that might be either unaffordable or tight for someone who's on a budget.

02:19 And those folks may wish to pay them off.

02:21 So these are people who want to repay their student loans.

02:24 They want to buy a house.

02:26 They want to pay off their credit card debt.

02:28 They have the desire to do it.

02:31 They just might not have the means.

02:32 And so what the IRS says is that if you borrow money from basically any other person, but

02:41 we're talking about families.

02:42 So if you borrow money from families, from related parties, as long as you charge interest

02:47 at a rate called the AFR, the applicable federal rate, and that is a rate that is published

02:53 every month by treasury, it's on the web and also in the federal register.

02:58 As long as you hit an interest rate at that number or above, then they're going to consider

03:04 it a legitimate loan.

03:06 And those numbers can be 4% and 5% right now as compared to a credit card that might be

03:13 22% or a mortgage that might be 8% or 9%.

03:17 Some of the repayment options for student loans are hitting like 12%.

03:21 So you can see that that could be a considerable way for somebody to make the payments that

03:26 they wanted to make, but they do it at a lower interest rate.

03:30 So it's a win in that regard.

03:33 So what are the potential risks that lenders face if they don't charge an AFR minimum?

03:39 So if you don't do it at the minimum, the IRS is going to look at it and say, you know

03:44 what, one of two things or possibly both.

03:46 One, we know that this was really a gift, right?

03:50 It wasn't a loan.

03:51 You didn't do this the way you were supposed to.

03:52 We're going to treat it like you made a gift.

03:54 And typically when they do that, the IRS is going to say that we're going to act like

03:58 it was a real loan, even if it wasn't, which means the interest that was payable is going

04:02 to be charged to the person who made the loan, interest free, even if they didn't receive

04:08 that money.

04:09 So you want to make sure that you have your paperwork done and that you've documented

04:14 that you're going to charge at least this amount in interest rates.

04:18 And then you also, you know, good paperwork would also say how long the loan is going

04:23 to last, right?

04:24 Because that also depends on the interest rate.

04:26 The interest rate can change under the AFR depending on how long the loan is.

04:30 And that's pretty normal because, you know, the loan rate for a 30 year mortgage is going

04:34 to be different from, you know, your payday loan, right?

04:36 It's the same kind of idea.

04:38 So you want to make sure that that is in writing.

04:40 And you also want to say how often you're going to be making those payments and put

04:44 all of that in writing just to make sure you're not going to have any, you know, any disagreements.

04:49 So could you elaborate on the documentation requirements for inter-family loans, emphasizing

04:54 the importance of paperwork and a signed promissory note and how these measures help prevent issues

05:00 with the IRS and potential misunderstandings?

05:02 So paperwork, as an attorney, I'm a big fan of paperwork.

05:06 So paperwork is always good because then there's no misunderstanding, right?

05:10 Nobody says later, "Oh, you said five and a half percent.

05:13 I thought you said four and a half percent."

05:15 Like there's not that kind of misunderstanding.

05:18 You have a schedule, a repayment schedule.

05:20 So that not only is that good for, you know, for the person who's receiving the money,

05:26 but as somebody I can tell you, I love deadlines because I put them in my calendar.

05:30 I know what I'm doing when, right?

05:31 Like, you know, when your credit card payment is due, it's really good idea to have a schedule

05:35 that says I'm paying mom and dad back on the fifth of every month or, you know, however

05:40 you want that.

05:41 So you love deadlines.

05:42 What is your Zodiac sign?

05:43 I'm a Libra, actually.

05:44 I love deadlines.

05:45 Maybe that's why.

05:46 What?

05:47 It's giving Virgo.

05:48 Okay.

05:49 I love balance and I think you achieve balance by documentation.

05:50 So, you know, again, you write all that down so that there are no disagreements.

05:59 You're saying how much you're going to pay, when you're going to pay it, and how long

06:02 you're going to do it.

06:03 That way, also, when the IRS is looking at it later, if they look at it later, you can

06:07 say, "Hey, we charged the right amount of interest.

06:10 We did all of this the right way."

06:12 Another piece of paperwork that you might want, depending on the kind of loan that you're

06:15 doing, is something that's sort of security, right?

06:18 So the typical way we think of this is a mortgage.

06:21 So if I was to go to a bank, they would take a note against the value of my home and they

06:26 would record it so that if something happened, I didn't repay them, they could take the house

06:31 back if they have something of value.

06:34 You know, grandma can do the same thing.

06:35 And even though it sounds like it, you know, it sounds a little onerous, it's actually

06:39 really a good idea because it helps you keep track, again, of who owes who what and under

06:47 what circumstances, right?

06:48 Because you're reporting the mortgage.

06:49 So there's no disagreement about how much was borrowed, when it happened, all of those

06:54 things.

06:55 But it also can give grandma a little bit of security in a couple of ways.

06:59 One is if something were to happen, grandma gets your house, which we tend to think of

07:04 that something happening as being maybe you don't pay the loan back.

07:08 And so, you know, that seems rather dramatic.

07:11 But there are other things that might happen where grandma wants to hold on to that security

07:15 interest.

07:16 For example, what if you get a divorce?

07:18 You bought a house with a spouse, you're getting a divorce, who owns the house?

07:23 Well, grandma owns the house, at least up until the part of the unpaid mortgage, right?

07:27 So that way she gets repaid, even if it's something that's a little out of your control,

07:31 like maybe it was your ex spouse's decision not to pay, right?

07:34 So there's lots of, you know, divorce is a good example.

07:38 What happens if something happens, you pass away early?

07:40 Again, we tend not to think we're going to pre-decease grandma, but what if we do?

07:45 So reporting the mortgage actually gives, I think, a peace of mind for grandma or your

07:50 parents or whoever has loaned you that money, that they know that they're either going to

07:56 get those payments or they're going to get the money that they loaned you back at the

08:00 end, which is significant.

08:03 So how can the strategy of making inter-family loans be beneficial for middle-class families

08:07 with smaller loans?

08:09 And what creative planning opportunities arise at higher income levels leading to additional

08:14 savings, including for estate and gift taxes?

08:17 Well, so I think, again, when we think about these inter-family loans, we're thinking about

08:23 rich grandmas, right?

08:24 Like our mind immediately goes to like Emily Gilmore, right?

08:27 Gilmore Girls.

08:28 So that's sort of, I think, where people think are going.

08:30 But, you know, sometimes I think the average student loan, and this is before the repayment

08:35 started, was something like $35,000.

08:37 It's a lot of money for a, somebody just out of college to pay back, especially at these

08:42 high interest rates.

08:43 But it might not be a lot of money for a grandma because she might have that in a CD that's

08:47 easily accessible, right?

08:49 So she could loan you the $35,000, you pay her back, you pay off your student loan, everybody's

08:55 happy.

08:56 That is something that can happen at the middle-class level.

08:59 And you have the benefit of getting the lower interest rates.

09:04 Grandma gets a stream of income, again, probably equivalent to the same thing she would have

09:08 in a CD or a savings account.

09:10 It's going to pay around, and maybe more than she would have been getting.

09:14 So, you know, in terms of economics, each of you are going to benefit.

09:19 And again, if it's something like a home or another tax break, student loans could also

09:24 fall into this category.

09:26 You get to preserve those tax breaks.

09:28 Just because you're borrowing the money from grandma doesn't always translate into losing

09:33 that tax break.

09:34 You know, there are some considerations you have to look at.

09:36 But, you know, it's, the general premise is that it still could transfer over.

09:41 And so that's a really good way for the middle class to benefit.

09:44 At the high network level, there's a lot of planning, creative planning opportunities

09:49 you can do.

09:50 I'll just mention one of them, which is that, well, actually I'll mention two.

09:55 So one is that you can gift a certain amount of money every year to people without incurring

10:02 a gift tax.

10:03 And that is currently, I think, going to be $18,000 in 2024.

10:08 And so that means that you can give that money without a tax consequence to anyone that you

10:14 give.

10:15 If you were in a position to loan this money to someone in your family, and maybe they

10:21 weren't in a position to pay it back, or maybe they paid it back over a number of years,

10:26 and you think to yourself, you know what, you've been so responsible this whole time,

10:30 I'm going to forgive part of this.

10:32 That gift could be used, you could use your annual exemption that we just talked about,

10:37 sorry, the annual exclusion that I just mentioned, the amount of money that you can give to a

10:40 person per year to forgive that tax break.

10:43 So there can be a good advantage there.

10:46 There's also some strategies where you can create trusts and sort of start building family

10:52 wealth and then loan against the trust.

10:55 The arrangements are actually called intentionally defective grantor trusts.

10:59 We sometimes call them IJIT trusts.

11:01 But IJIT trusts or defective grantor trusts, it's this little quirk in the tax code that

11:06 allows someone to set up a trust for estate tax purposes and move money outside of their

11:12 estate.

11:13 But for income tax purposes, the IRS looks at it and says, but you still own it.

11:18 And that actually creates that dynamic, creates a lot of opportunity for planning.

11:23 It can get pretty complicated.

11:24 That's the kind of thing that you definitely want an advisor for.

11:27 But if you're in that higher net worth strategy, or sorry, in that higher net worth category,

11:32 and you're looking for ways to loan money beyond just writing a check and actually get

11:38 some additional estate and give tax benefit, something like an intentionally defective

11:43 grantor trust scenario kind of tied to an inter-family loan is a really good way to

11:48 do that.

11:49 Wow.

11:50 So this is how to beat high interest rates with the Bank of Grandma.

11:54 Thank you so much for joining me today, Kelly.

11:57 Thanks for having me.

11:58 Absolutely.

11:59 Thank you.

11:59 [END]

Category

Transcript

Be the first to comment

Recommended