Even the rich are having trouble getting credit in today’s tight environment.
But for the wealthy, there’s always the family bank.
With interests rates at all time lows, families can essentially gift money at below market rates and avoid paying steep gift taxes on amounts that exceed annual or lifetime gift tax exclusions.
For example, say junior wants to buy an apartment to live in while he attends New York University. He needs a downpayment of say $30,000 to pass the co-op board. The parent has already gifted the child $13,000 that year and doesn’t want to dip into his $1 million lifetime exemption.
Parent and child go to a lawyer to draw up a promissory note lending the child $30,000 at rock bottom interest rates for example.
“This provides a credit opportunities where children can’t get credit,” said Carol Kroch, a managing director of wealth and financial planning for Wilmington Trust. “A child could also invest money borrowed this way and earn money on it. We have families doing this all the time to buy summer homes and cars.”
How does a family loan work?
The Internal Revenue Service sets the rate monthly (around the 20th of the month) on which the family loans are based. Right now those rates are really low. In March, the zero to three-year note carried an interest rate of 0.64% and the three to nin-year note was 2.69% (compared with say 6.6. for a commercial car rate).
“Your child can’t go anywhere else and borrow for that,” Kroch said."Right now to be able to lock in a loan at that rate is quite desirable.”
If you. If you go back 10 years, the short-term rate in January of 2000 was 5.88% by comparison. The longer the note the closer it gets to commercial rates.
At rates this low the child could also borrow money and invest it over say nine years with pretty good certainty of making more than 2.88% per year. Not only does parent avoid a gift tax of 35%, but the child gets to keep any appreciation over and above 2.88%. “The second opportunity is an arbitrage opportunity,” Kroch said. “You lend them a million at low interest rate and child can earn more and keep the extra.”
“It’s about being able to make money available at reduced rates without being subject to gift tax,” she said.
Since the view is that over time interest rates will be going up, locking in such a low rate now on any financing is desirable.
A wealthy individual could use a family loan for example, to refinance a relative’s house more easily than going to a bank, Kroch said. But she warned that a high-net-worth individual needs to get everyone’s expectations out on the table.
“Lending the money for the house doesn’t mean the you get to pick out the living room sofa," she said.