Reprinted from the Balanced Report - first published: Winter 1989
An article about loans to family members
For some months Marie (my wife) and I explored and consulted with other financial planners to put together the perfect plan for family loans, to help our children buy their first home. We think we have come up with the perfect plan.
There are two major problems with this type of loan. The parents seldom get their money back and if the child is laid off or encounters some financial difficulty, the parents' monthly interest payments are usually the first expense to be cut. This can cause some hardship to the parents if they are dependent on the monthly payments for their retirement income. Many of our retired clients are well off financially or at least have more coming in each month than they require. It is the kids who are struggling. There is a way that you can help each other. A principal residence is probably the biggest single investment of your child's lifetime. It will also probably be the best investment of their lifetime if the future is similar to past real estate values. A principal residence is one of the few tax havens. There are many other investments that offer some tax deduction by way of a deferral of taxation. A principal residence remains the only tax-free real property investment (within limits) when it is sold. The sooner they get into their own home the sooner they can benefit. The problem is that some years the price of a home has gone up faster than the ability of young couples to save for the down payment, putting their first home further and further out of reach.
In our own family the problem of trying to help our children is restricted by the size of the family (6). We therefore put some restrictions on the programme to defer their all asking for assistance at the same time, which allows us to prepare financially for their requests. We did not want any interest income because this is the most highly taxed type of income. We would rather have capital gains income, because of its preferential tax treatment.
Here is how the programme works. We offered each of our children to loan them on an interest free basis 10% of the purchase price of their first home to a maximum loan of $20,000.00 each. No monthly payments are required. We put a ten-year limit on the loan, as we will require the funds at that time for our retirement. Another condition is that the loan is to be secured by a second mortgage at zero percent interest. The child has to be married and the home in joint names. In the event of a marriage break up the loan would be secured by the second mortgage. We also put in another restriction that if the property was not in British Columbia, a lesser amount would be available. This is just an outright bribe to encourage our kids to settle in B.C. Canada where we now live and where we could visit more frequently and see our grandchildren more often. The loan is due to be repaid in ten years or when the house is sold or refinanced whichever comes first.
When the house is sold or in ten years we are paid an amount equal to the ratio that the original loan bore to the original purchase price. In other words if we loaned them 10% of the purchase price we will receive 10% of the selling price, or appraised value. This profit will be a capital gain to us for tax purposes. The advantage to the kids is that they don't have to make any monthly payments. They are also able to qualify for a higher first mortgage because the second mortgage does not require any payments and therefore improves their debt-servicing ratio for the first mortgage. As the home is their principal residence it is a tax-free profit to them (within limits) when they sell. The local real estate board quotes an average annual compound rate of growth for the area of 10.7% for the last 25 years. This should provide a nice capital gain for both parties at the end of the term, based on historical data. It helps the parents invest for the future and guarantees a return of their capital and it gives the kids a huge break to help them acquire their first home
Copyright –
www.money-software.com About the Author
Peter F. Baigent CFP, CLU, CHFC, RFP. is a Past President of the Canadian Association of Financial Planners for British Columbia, a former Director of the Canadian Association of Financial Planners. He has spoken across Canada on financial planning matters and has taught courses for the Chartered Financial Consultants & Certified Financial Planners degrees. He is the founder of Money Minders Software which produces financial planning software.
