The Bank of Mum & Dad
With Australian property prices continuing to increase in value, so too is the practice of Mum and Dad giving their children a helping hand to get into the property market.
The doors of the Bank of Mum and Dad are well and truly open for business!
Whilst parents love to help their children it comes with a few unexpected surprises.
Before you open the door to your very own Bank of Mum and Dad here are some things for your to consider.
There are a number of ways that you can help your children out financially:
1. You can guarantee their loan;
2. You can lend them money; or
3. You can gift them money
All three of these options come with their own challenges and issues.
Being a Guarantor
The first thing you need to do if you go guarantor on your child’s Bank loan, is seek your own financial and legal advice on the pros and cons of this. You need to make sure you are fully aware of all the circumstances under which the repayment of the loan will fall to you. Because as the guarantor, you are basically guaranteeing the repayment of the loan if your child can't repay it themselves.
If your child’s mortgage repayment if $1,400 per month and they can't pay it, the bank will expect and insist you to take over the repayment of the loan. Can you afford the repayment of $1,400 per month?
It's worth keeping in mind that the average mortgage in Australia is heading towards $500,000 and with an interest rate of 4.25% and a loan term of 25 years to repay the mortgage, the repayment is around $2,700 per month. Know what you are getting in for!
The bank will want their money back and have been known to sell the house of the guarantor to get it. So the ultimate downside risk is that you could lose your home.
A number of banks offer loans where by the deposit for a home is secured against the home of the parents. Whilst this may seem like a good idea, it comes with downsides too.
If the parents want to sell their home, these guarantees can cause problems if they need to refinance or want to buy a new property. They may need to repay a portion on the child’s mortgage from the sale proceeds of the sale of parent's home. Once the parent's home is sold, the bank no longer has that asset as security. So instead of having the old home as security they will require either a portion of the kids loan to be repaid or if the parents are buying a new property, they will want a mortgage secured over the new property.
It may preclude the parent from refinancing to a different provider. The bank that the kids are using will want a first mortgage over the parent's home. This will typically mean that both the parents and the kids will need to use the same lender if the parents still have a mortgage over their home.
It may affect the parent’s ability to borrow more money for themselves eg for another investment because a portion of their equity is being used to secure their children's home. As such this portion of the equity is not able to be used for any other purpose.
Parents may be able to limit their liability by having the guarantee attached to a term deposit instead of their home, this gives greater flexibility but they are still at risk of losing the money if the child defaults.
Get the guarantee released as quickly as possible
If the value of your child’s property has increased and/or they have paid down enough of their loan so the bank will lend to them in their own right, ask to be removed from the loan as the guarantor. Once this is done, your liability will end.
This should be reviewed on an at least annual basis. If the property value is not increasing, it may be worth having a discussion with your kids if they can increase their repayments so that their equity level in the property increases any way. This will give you the same result and you can ask to be released as guarantor.
Lending the money to your child
Firstly, decide if it’s an interest free loan or if you’re charging interest. Most parents option for an interest free loan to their children.
But if you do decide to charge interest, you will need to declare the interest you receive as income in your tax return and pay the required rate of tax on it.
Banks generally don’t like deposits that are funded by a loan from Mum and Dad. That is, they wont accept them as a deposit, because effectively the child has used 100% borrowings to fund their property purchase. It's showing the bank that they haven't been able to save enough money for their deposit, plus they owe another debt that the bank isn't in control of.
If you are going to lend your child money, make sure the loan is documented and that all terms of the loan are set out, including when the loan is to be repaid and under what special circumstances it must be repaid. Getting legal advice on this is important.
This becomes very important if your child happens to get divorced. If the money is clearly a loan, then it will be viewed as a debt of the union and treated like any other debt, meaning it must be repaid before any splitting of assets is undertaken. Documentation is the key to proving whether or not it will be treated as a loan or a gift.
Whilst this seems like a good idea that will get around the banks' problem with parents lending money to kids, it comes with its own issues.
Equality between siblings. If you lend to one do you lend to all. Can you afford to do this?
What happens to the money if your child’s relationship to their partner breaks down?
Answering Point 1
If you don’t have the cash resources to give an equal amount to all your children, a way to make sure there is equality is to put a clause in your will documenting the amount of money you gifted to one child and that this is to be taken into account before dividing the estate up between all your children. You need to speak to your solicitor about this to make sure that any such clause is valid.
Answer Point 2
If you child’s relationship with their partner breaks down and the property is split up, your gift is considered an asset of the union and it too is most likely going to be split the same way as the rest of the property. After all a gift isn’t expected to be repaid. You have to be able to live with this potential situation down the track.
Affordability to you
Can you really afford to gift or lend money to your child?
What effect is this going to have on your own finances?
Can you afford to lose the amount of the guarantee?
Will you need to dip into your superannuation to do this? If so, are you still going to be able to fund your own retirement?
Can you afford the repayments if your child does default on a loan that you have gone guarantor for?
If the bank wont lend them money, should you?
Whilst some of these questions might seem a little harsh, they need to be asked and answered honestly. I'm sure your children would not want you to put your own retirement at risk.
All of the above apply equally for business loans as well. However, given the nature of small business, it is likely the risk of default is even higher.
You should most definitely get your own legal and financial advice before going guarantor on a business loan. Typically a business loan wont be secured against any items in business and therefore, need to be secured against someone's home or other assets, the risk of potentially losing your home is even higher under these situations.
The Family Relationships
Your relationship with your child and the family units’ overall relationship needs to be looked at. Again honest answers need to be given to these questions:
Can the family relationship survive a default?
What will happen if you are forced out of your home due to a default on a loan by a child?
How will you react, how will they react?
How will your wider family react?
The only hard and fast rules you should follow when you are thinking about opening the doors to the Bank of Mum & Dad are to seek your own personal advice from trusted professionals. They can help you answer the questions you need to ask in a honest and forthright way. They will be able lead you through the pros and cons of the consequences of helping out your children.
This advice is general in nature and doesn't take into account your personal circumstances. If you need advice in making these decisions please contact us for assistance, email us by clicking here or phone us on (07) 3018 0587.
Here's the link to my chat with Trevor Jackson on ABC 612 on the topic: