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I'm the friend. My mom needs a loan from me and figures involving a bank might avoid some headaches. She wants me to lend her 20K. Wire it to the bank. Then the bank will (presumably) lend her 20K. Do banks do this?

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I didn't understand the process, you give 20K to the bank as a collateral, and the bank lends this money to your mom? Why not just give the money to your mom directly? – littleadv Jul 30 '12 at 19:09
I don't want to bother with micropayments, and harassing her for monthly payments. – iago Jul 30 '12 at 19:18
This is actually rather common; the loan becomes "secured" by the up-front payment, and the bank will thus lend at a lower rate. Contrasting with a direct gift, the lending person avoids taxes (an informal loan of money is considered a "gift" for tax purposes), and the lendee can build credit history by repaying the bank who reports to the credit agencies. – KeithS Jul 30 '12 at 20:11
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Regardless of which option you chose just assume that the money is gone. That way when you get the money back you can be happy. Don't say I don't need the money for x years, and also expect it to be the college fund. – mhoran_psprep Aug 5 '12 at 23:48

4 Answers

up vote 2 down vote accepted

Short answer: yes, you can put up collateral for someone else's loan. The bank will be happy to take your money, give it to the other person, and return it to you on completion of the loan (keeping the interest the security makes on the money market and the interest they're charging the other person for themselves).

If the above doesn't sound very appealing (you don't see any benefit from your investment, and can be left holding the bag if your friend defaults on their loan), it really isn't a great way to spend your money. However, as assistance to someone else, it provides several advantages over directly transferring the money:

  • The lendee gets a better rate than they normally would from the bank - Basically, from the bank's perspective, the loan's covered, so there's very little risk of a default leaving them holding the bag. As such, they can typically offer rock-bottom, cost-of-capital rates.
  • The lendee builds credit history - Since the lendee is making payments on a legitimate, structured loan to an entity that reports to the credit agencies, this is a very good way to help the lendee build good credit.
  • You avoid the gift tax - If you lend over $13k, unless there's a contract between the two of you stipulating a schedule of payments, it's a "gift" as far as the IRS is concerned and you will be taxed on the amount above the exemption. EDIT: The $13k figure (going up to $14k for 2013) is only the limit if the loan is not a loan, but in fact treated as a gift (i.e. no reasonable prospect of repayment). For bona fide loans, there is no fixed upper limit on the amount you can loan, but the gift tax will be determined based on the difference between the interest charged and the "applicable federal rate" (this rule is found in IRC Sec. 7872; check IRS.gov for monthly Rev. Proc.'s listing newest AFR's). Last time I checked the short-term and medium-term rates were around 0.2%, so if this still holds it's an excellent time right now to "gift" your credit at little to no gift tax cost. One can even take advantage of this by making so-called "back-to-back" loans- taking out a HELOC at 4% and subsequently loaning proceeds to your child at .2% (or whatever the current AFR), producing no taxable gift on the 3.8% difference.
  • The lendee may be able to deduct interest - depending on the type of loan (maybe the $20k is the 15% of an 80-15-5 mortgage), the interest paid on that loan can be tax-deductible. A personal loan between friends? No way.
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Yep. That's the risk. If your mom defaults on the loan, the bank will take any unpaid principal, interest and fees out of the collateral amount and may return the rest to you (or they may keep all of it as a penalty), hanging you out to dry. It's a tax write-off, but for you that would probably be a consolation; if you make $50k after deductions, now you made $35k (you can either take your $5k standard deduction or itemize the $20k. but not both), so you'd get between $3k and $4k off your tax bill. You'd have to sue your own mother for the rest, and she could demand a jury trial. – KeithS Jul 30 '12 at 20:41
I just don't understand this process and why this is being considered at all. The OP gives $20K, say, to a bank which turns around and makes a loan to Mom and charges her interest (which the bank keeps). At the end of the process (say in 5 years), the OP gets $20K back from the bank if Mom successfully makes all the required payments, less if she defaults. Mom has to make monthly payments, and gets hassled if she is late in making a payment. She also gets a bad credit history if she defaults or misses payments. I see only down sides, but the OP has accepted the answer (without an upvote). – Dilip Sarwate Jul 30 '12 at 20:56
I told you that it wasn't an extremely appealing option in terms of risk/reward. But, my father-in-law did pretty much the same thing to secure a car note for my wife; basically my grandparents sold her the car for $3k since they couldn't drive it, my FIL secured that loan with cash, and she paid it back at next to nothing through the bank while building good credit on the loan. There are advantages to doing it this way versus keeping it under the table, as stated in my post; virtually none of them benefit the OP directly, but I fail to see how your solution would be any better for the OP – KeithS Jul 30 '12 at 21:21
However, I fail to see how your solution would be any better for the OP than this. You're advocating that the OP not only give the money to his mother under a relatively lax "contract", but also pay her the amount of the interest, with the under-the-table arrangement that she then pay it back to him, thus making the huge gift look like a loan and keeping smaller gifts under the exemption. The IRS would recognize this as blatant tax evasion, there's zero incentive to pay it back except guilt, and the only method of enforcement is for the OP to sue his own mother. – KeithS Jul 30 '12 at 21:26
@DilipSarwate (the OP has insufficient rep to upvote, but can mark an answer as accepted.) – Chris W. Rea♦ Jul 30 '12 at 22:07
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up vote 4 down vote

There is no need for micropayments, monthly payments, or harassment.

A loan agreement can be drafted that your mom makes one payment annually to you instead of monthly payments. Depending on what she (and you) might be comfortable with, this payment could be interest only, or partly interest and part repayment of principal. Or you can set it up so that there is a balloon payment due when the loan terminates (say in five years' time) and she pays back the entire principal and accumulated interest. If you trust her to pay back the money, you don't need to ask for collateral or security, and you don't need to turn the debt over to a collection agency or send large men with baseball bats to call on Mom.

If you just want mom to return the principal when she is ready to so so, and don't really want to charge her interest, then set up the loan to require annual payment of interest only (and the entire principal at the end of the agreement). Then, each year, a few days before the interest payment is due, send her a check for the interest due as a gift. Mom deposits the check in her account and sends back the interest payment to you. So, no harm, no foul: you have made her a gift (presumably less than the $13K exemption), she has paid you interest, but there is no net transfer of money, and as far as the IRS zebras are concerned, this is a legitimate loan. Do keep copies of the paperwork, though, and be sure to report the interest payment on your income tax returns as income to you. By extension, if you don't really want the money back, set up the loan so that the annual payment is $13K and is part the annual interest due and part the principal until the loan is paid off.

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Only one question; if the OP's mom defaults on this agreement (which is already extremely disadvantageous; he's loaning a large sum of money and then paying her the interest on it so she can pay it back), is he going to sue his own mother for strict performance of the contract? If the bank is requiring the loan to be fully secured in order to even make it, then I think his mother would benefit more from building credit by paying the bank, and she sounds like a HUGE default risk. – KeithS Jul 30 '12 at 20:47
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One should not loan mom money. She gave you life, you should give her $13,000/yr with no strings attached. – JoeTaxpayer Jul 30 '12 at 21:31
@JoeTaxpayer While I agree with your sentiments, that does not seem to be something that the OP wants to do, and I didn't want to be in a position to be be preaching at him (cf. a recent discussion on meta.money.SE). – Dilip Sarwate Jul 31 '12 at 0:12
I'm sorry. I meant this tongue-in-cheek. I +1 you, your answer was spot on. – JoeTaxpayer Jul 31 '12 at 1:01
up vote 2 down vote

Since this is the reasoning:

I don't want to bother with micropayments, and harassing her for monthly payments.

You must do one the following:

  1. Provide the money to your mom as a loan (i.e.: with a note and interest) payable when the full repayment of the loan to the bank is done (i.e.: balloon note). The terms of the note should be that the money to be used as collateral for the secured loan from the bank.

  2. Provide the money to your mom directly. In this case you have to pay gift tax on $7K (above the 13K exemption limit).

Since you want the money back - you'll probably want the option #1. Your interest rate should be above a certain level to avoid reclassifying it as a gift by the IRS (your tax adviser can help you with that). Your mom will pay interest to the bank on the secured loan, and to you on the collateral (unless you wave it, subject to gift tax, again - talk to the tax adviser). You will only need to harass your mom about the balloon payment in the end.

This is not a tax or legal advice. Talk to your tax adviser and a legal counsel about the details and additional options.

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For (2) you mean not as loan? So long as the loan is legitimate, there's no gift tax. – JoeTaxpayer Jul 30 '12 at 19:52
Yes, (2) is not a loan, its a gift. – littleadv Jul 30 '12 at 20:24
Actually, gift tax does not have to be paid on the $7K if one is willing to reduce the lifetime combined gift and estate tax exclusion (currently $5M or so, scheduled to go down to $1M or so unless Congress does something) by $7K. – Dilip Sarwate Jul 30 '12 at 21:00
Dilip - well done. Exactly. – JoeTaxpayer Jul 30 '12 at 21:30
up vote 0 down vote

I don't want to bother with micropayments, and harassing her for monthly payments.

Alternative approach to lending her $20K, arranging for her to pay you back $x per month, and having to (as you say) harass her for micropayments.

Instead, you give her the $20K, and she sets up a savings account with a monthly direct debit deposit of $x. The bank takes care of the monthly "payments" into the savings account, and at the end of the loan period, you've got your $20K, and instead of the bank making interest off your mom, you make some interest out of the savings account.

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