How to Loan Your Adult Child Money

Senior adult woman talking to her son.

The financial and emotional costs of lending money to an adult child runs high.

With credit markets still tight, it can be hard to secure a loan and many cash-strapped adult children are seeking help from the bank of mom and dad. Experts advise that parents do in fact act like a bank and set an interest rate (even if it is far less than a traditional bank rate) and create a payment plan.

But it can be a hard decision on whether to make the loan: You want to support your children, but you also want them to learn the lessons saving for what they want, and financial hardship, teaches.

“Parent-child loan arrangements can be great to help give kids a head start by buying a house, starting a business or going to school, and they can be a valuable part of many parents' estate plans,” says Alvi Aggarwal, an estate planning attorney with One Point One Legal in Alexandria, Va. “There are some legal and tax concerns, but it's easy to avoid major pitfalls by properly planning and carrying out the transaction.”

For example, with a few complicated exceptions, gifts or loans to children more than $13,000 are subject to gift tax unless interest in the amount of at least the Applicable Federal Rate (AFR) is charged, which is about 2.72% for a 10-year note. If you don't want your child to pay interest or make substantial payments, there are a few legal ways around it with the help of a professional.

But when a kid needs an immediate loan to get through a temporary hardship or life- changing decision, here are a few expert guidelines to make the process as smooth as possible and ensure you get paid back:

Validate the child's reason for needing the money. Talk about how the money will be used to make sure you’re comfortable making the loan and that it will be used wisely. Ask whether the child has taken action to increase income and reduce expenses (are they thinking of taking a second job, cutting costs?), and make sure they have a detailed re-payment plan.

Stan Molotsky of SHM Financial Group in New Jersey recommends only lending money in vital situations like making rent, buying food or paying bills.

Make it clear you won't always loan money. Setting clear expectations and loan terms avoid repeat trips to the bank of mom and dad.

“Even in college, one shouldn't be dropping coin on their kids just because they say they need it,” says Certified Financial Planner Adam Koos, with Libertas Wealth Management Group. ”The more you give them, the more you'll artificially prop up their lifestyle. The longer you continue this habit, the longer the child will accept it, and the harder it'll be to fly on their own when you either decide to stop helping or your retirement fund decides for you.”

Draw up a contract. A loan arrangement between you and the adult child should be treated like a normal creditor-debtor relationship. A contract may cause discomfort and raise questions about trust, but is necessary, says Molotsky.

The contract should include the total loan amount and interest rate, payment schedule and default and late penalties. “It's a fine line parents walk between lending money to children and spoiling [them] with loans that children assume are gifts,” adds David Ogman, financial advisor for the Shapiro Ogman Group. “Having a contract will set the boundaries from the start.”

Charge reasonable interest.  Danny Kofke, author of A Simple Book of Financial Wisdom: Teach Yourself (and Your Kids) How to Live Wealthy with Little Money, suggests charging 5% interest on loans to children. “It may be difficult to charge your own child interest but you are actually doing them a favor in the long run and teaching them a valuable lesson,” he says.