Take your own dreams into account
In this Guide, we’ll help you consider:
- Relationship Risk
- Financial Risk
It’s great to help your children but don’t risk your financial future or relationship with them.
Inviva has worked with risk experts to help people understand some of the risks of lending money to family.
The risk assessment questionnaire below is designed to guide you through the risks and implications when helping your child. The emphasis is on risks (bad things that could go wrong) rather than returns (great things that result when all goes well).
While some of these questions may be confronting, they could stop family heartbreak and financial catastrophes down the track.
A guideline for determining how much you can afford to help is to only lend what you can afford to lose!
This risk questionnaire consists of two parts:
- The non-financial area is checking that the relationship between you and your child is strong enough to weather any storms that may occur.
- Checking your financial capacity is able to withstand the catastrophic event that the child doesn’t make repayments.
Relationship Risk
Reason for lending
Parents should be clear why they are gifting or lending money. For example, the borrower (child) can’t get funds elsewhere (either for a deposit or to make ongoing repayments); and wants to avoid costs such as Lenders Mortgage Insurance.
- List the main reasons you are lending money.
Financial Risk appetite
Risk appetite refers to the level of risk a person is comfortable taking on in the pursuit of their goals and objectives. Some people tend to be financial risk-takers – they will seek out higher risk ventures which could have higher returns.
For example, risk-takers might invest in a friend’s speculative start-up business. Other people are more risk-averse – that is, they are hesitant to take on risk even for higher potential returns. For example, risk-averse people are more likely to invest in safer bank deposits or established businesses.
This underlying propensity to take on financial risk applies regardless of whether people are in a strong or more challenging financial situation.
- Neither approach is right or wrong Typically, are you more likely to be risk-averse or a risk taker when managing your financial decisions?
Relationship obligation
Parents often feel obligated to enter into loans/gifts out of a sense of duty, guilt or pressure being applied, or love and concern for the borrower. Socially isolated adults may be more vulnerable. You should consider whether the benefits of providing the money justify any risk to your financial position.
- To what extent do you feel obliged to make the loan/gift, even if there is a material risk to you financially?
- If so, why do you feel obliged to provide the loan?
Resolution of conflict with family
Many parents find conversations with their children about lending money to be very difficult. The discussions have to cover things that can go wrong that cause financial stress (e.g. ill-health, relationship breakdown, unemployment, excessive gambling). Other considerations could be an extravagant lifestyle or susceptibility to influence from others, including partners.
- To what extent are you comfortable having these open discussions in advance of setting up the loan and dealing with conflict if there is a subsequent problem with repayments?
Repayment Issues – response by child
If the child is having problems making ongoing repayments to you, or repaying the loan completely when it becomes due, the child may not listen to the ‘difficult conversation’ or act in a way to resolve the issues. This could be affected by their partner/spouse and any other household financial decision makers who may disagree with the method or extent to which they will need to act to resolve the issue.
You may have to convince them to act on your requests and find the right course of action, even to the extent of taking legal action.
Your circumstances may change, and you may need to have the loan paid back earlier than anticipated.
Some hard conversations may need to be had.
- If there is a problem with repayment/repaying the loan, to what extent do you think the child and any related decision makers will do everything they possibly can to understand and take action to resolve the issue?
- Are you confident you can have those awkward conversations with them easily, and will be able to seek legal recourse in extreme circumstances?
Rules – tax and legal
There may be legal and tax implications associated with a home loan, which can vary by State or Territory.
- Do you understand all the potential legal and tax implications of your gift or family loan?
Financial Risk
Right loan amounts and concentration of funds
If you are using investments, your home equity or taking a loan to fund the deposit, the amount that you can comfortably put toward the deposit is affected by how much you can afford. Unless you have ready, uncommitted savings, you will likely be diverting some of your wages or income from your investments or access your home equity. Note: In a direct loan, if the child is paying you a higher interest rate than your investments, this may not be an issue.
- To what extent are you in a comfortable enough financial situation to make a loan or gift that it won't materially affect your cash flow, lifestyle or future plans?
Repayment reserves
If things go wrong, the child may not be able to make their repayments when they are due. So, it’s important to know if you want or can afford to take over the child’s loan repayments (if there is a bank involved) and/or live without the investment income (if it is a loan directly between you and the child).
In the shorter term, you may need to curb your lifestyle or get more income (from a second job, for example). In the longer term, you may need to find another way to recoup your funds by selling assets, such as shares or an investment property. It’s important to understand your ability to do this; in the worst case, it may even result in you having to sell your house.
- To what extent would the borrower being unable to make repayments/repay you affect your lifestyle and assets in both the short term and the longer run?
Risk of concentration
By giving the child a loan, you may expose yourself to ‘concentration risk’ – having a high proportion of your assets tied up in one investment. As you get towards retirement age, or are retired, the potential effect on your portfolio is very important, as you won’t have as many years to earn offsetting income.
What would be the impact on your retirement income and the proportion of your assets if the loan was never repaid by the borrower?
- If lending or gifting, will the impact on your total wealth be affordable in the long run?
Ramping of payments
Typically, if the child is going to default on payments, it might occur in the first few years. So, if you can afford it, it may be helpful to charge a lower interest rate to the borrower for the first few years or provide an interest free loan for a while and structure repayments to increase over time.
- To what extent are you in the position to afford lower repayments (i.e. accept reduced investment income) to help out the child?
Rule of thumb
A rule of thumb often used by commercial bankers is that loan repayments be a maximum of 30% to 35% of your take-home income. As you are contemplating a loan for your child, you should take into account other loans when you calculate the ratio, including any credit cards, personal loans, equity loans, mortgage payments.
- What is the ratio of the amount of your total loan repayments as a percentage of your total income?
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