When you hear the phrase “lender of last resort,” what comes to mind? Do you think of the Federal Reserve as The Banker to all banks? Or do you perhaps instead think of your parents, who – like the Fed – have always been there as a source of liquidity?

Let’s face it: We’re experiencing some significant cash shortages these days due to lost jobs, cranky creditors, and shrinking asset values. Americans are spending less, but there are still those unavoidable big ticket items -- autos, tuitions, homes  -- that must be financed if we are ever to get ahead. The banks and credit card companies are no longer talking to us, or are changing the rules so we no longer want to talk to them.  You probably hate to go there, but lately you may be wondering whether the “Bank of Mom and Dad” is still open.

Borrowing from family members can be bad business. Unfortunately it is easy to take one’s family for granted, and the default rate on family loans makes our current mortgage crisis look like a polite hiccup. When it’s a choice between repaying a parent whose job it is to love you forever no matter what, or a faceless institution holding the future of your FICO score in their impersonal files, can you guess who gets paid first?   

But if the incentives to make good on the debt are weaker than those for commercial loans, cash from kin can still come with all sorts of unwanted emotional strings attached, leaving you not just in monetary, but moral, bondage to your parents. When you owe them money, your parents may start asking pesky questions about your activities and spending habits that you haven’t dealt with since your wonder years.

It’s possible, however, to make a family loan a win-win for all concerned. Your parents might be interested in lending you money at a rate that is higher than the current lousily-low rates on money markets and CDs; yet this rate could be a lot lower than what you might have to pay a bank – or worse, a consumer loan or credit card company.  Right now the spread between what you can get by lending cash and what is being charged is wide enough for the whole ‘fam damily’ to occupy quite happily. 

To avoid a disaster in which everyone stops speaking to one another at the next family get-together, keep these tips in mind:

• Put it in writing. Your loan needs to be spelled out in terms of amount borrowed, term of loan, frequency of repayment, and the annual rate of interest. For big loans – such as for a home purchase -- you and your parents may want to go a step further and actually secure the loan with a recorded interest in the home or other asset.
• Automate it. Don’t leave your payments up to your emotional or financial state at the time they are due. It’s too easy to let them slide, because “after all, it’s Mom and Dad, and I am sure they would rather I used the money for something else.” Set up an automatic transfer out of your account into theirs.
• Keep it professional. Create a spreadsheet of the loan, tracking the amount of principal and interest paid with each payment and providing a report to your parents. Talk to a CFP^® professional or an accountant to understand whether and how much interest is tax-deductible to you, and reportable as income by your parents. (There are special IRS rules which eliminate some of the tax consequences of loans between related parties.) 

Check out www.virginmoney.com, brought to you by Richard Branson of Virgin Airlines fame.  For a fee, you can sign up for third-party servicing and tracking of a family loan. The benefit to all parties: Because these loans look and feel like real third-party transactions, you are apt to treat them as such.

Finally: If you have siblings, consider letting them know about the arrangements you have with Mom and Dad, thereby remaining accountable to them as well as to your parents.  A lot of confusion and resentment can be avoided if the facts are shared openly with other family members.   You don’t necessarily have to tell everything to your sibs, however.  Your parents may have different interest rates depending on who they like better!

-- Eleanor K. H. Blayney, CFP^® , Consumer Advocate for the Certified Financial Planner Board of Standards