When money is a little short, getting a loan is often a reasonable way for someone to continue on with his plans. In some cases, doing so actually can put you in a better financial position, securing assets or investments that can earn you money over time (business loans are a good example). The trouble is, traditional loans require people to be at the age of consent (18 in most states) because of contract law, and they also usually require some credit history.
Your child likely doesn’t meet either of these requirements yet, but there are times when a loan could make sense, such as borrowing a little cash to buy a used car for a job. If your child can’t go to a regular lender for the money they need, they’ll likely come to the Bank of Mom and Dad. If you decide to go ahead with loaning your child money, follow these three basic guidelines to avoid potential problems.
Put the Loan Terms in Writing
There are two main reasons why you want to formalize the terms of the loan you give your child. The first is so you and your child both are very clear on how the loan needs to be handled, and so you have a reference to use if necessary—misunderstandings can and do happen. The second reason to draw up a loan contract is that, in the real world, no lender hands over money without first having you sign on the dotted line. If your child has to do this with you, it won’t seem like such a big, confusing deal when they need to do it with a lender later.
Charge Interest or Use Collateral
Many people believe that it’s not necessary to charge interest or secure collateral on a family loan, just because the borrower is a relative. The idea is that, somehow, the biological link simply negates the risk of financial loss. The problem with this is that people who borrow from family members typically are either high-risk borrowers anyway (they don’t qualify for a loan with a regular lender because of credit or income problems), or they don’t have the experience of handling a loan and therefore are bound to make some mistakes. Not having interest or collateral on a family loan only increases the risk of nonpayment, because without these conditions, the borrower doesn’t really have much incentive to pay as agreed. By including them in your family loan, you’re more likely to get your money back and your child will learn how interest and collateral work.
Keep Loan Amounts Small
It’s not unheard of for family loans can get into the thousands of dollars, such as if your child wants to borrow money for an extended summer camp or to cover a security deposit and first month’s rent on a first apartment. The issue here is that, the larger the amount of money, the bigger the conflict is if the money isn’t paid back properly. In principle, your child needs to see a $5 loan as being just as important as one for $5,000, but the reality is that people emotionally prioritize, and by keeping the loan amounts smaller, you’ll be less likely to fight about the money if problems come up.