Over the past decade, millions of Americans have built up massive debt in the form of home loans, consumer loans and credit card debt. In order to help catapult America out of the current recession, our government has orchestrated artificially low interest rates. Herein lies a time-sensitive opportunity. If you are a parent or grandparent who is willing to help a child or grandchild out by making a loan, there may never be a better opportunity than now. The federal government requires that you charge a minimum interest rate on loans between family members. Right now those rates are at historical lows but I don’t expect them to stay there for long. My guess is that interest rates will begin to rise sometime in the second half of this year as the Federal Reserve begins to address the problem of rising inflation. The current minimum rates, called Applicable Federal Rate (AFR) are as follows:
For loans of three years or less: 0.57%
For loans exceeding three years up to nine years: 2.45%
For loans exceeding nine years: 4.11%
Let’s look at a couple of strategies for taking advantage of the current situation:
Slash children’s cost of debt. You could loan your child money to pay off existing high interest rate debt. Interest being charged on many credit cards has soared in recent months as credit card companies attempt to reduce losses on rising defaults. Consumer loans, likewise, typically carry relatively high interest rates. Your loan could allow your child to either substantially lower monthly payments or conversely, increase the speed of pay-off under the same payment schedule. For example, if your daughter had credit card debt of $10,000 at 18.9% interest rate, interest costs would be $1,890. If you loaned her $10,000 to pay off the credit card using a three year note at the current AFR, her interest would be just $57. The difference in interest amount, $1,833, could be applied to principal reduction and significantly accelerate the payoff of the debt.
Create an investment advantage for your children. While the stock market has had a meteoric rise over the past ten months, it’s still about 40% below its high in 2007. Many stock market prognosticators believe the market will do well in 2010 as the economy continues to recover. Consider this strategy: Make a three-year interest only loan to your child using the 0.57% AFR and have your child invest in a basket of blue chip dividend-paying stocks yielding 3.5% to 4.5%. The dividends will provide cash flow to make interest payments with plenty left over for either reinvestment, savings or additional personal cash flow that can be used to pay on other debts or expenses. Three years should be plenty of time for the stock market to move higher, reaping capital appreciation as well. At the end of three years, you could have your child repay you from a partial sale of the stocks or you could renew the loan at the then Applicable Federal Rate. Wealthy families could use this strategy to make large transfers free of estate taxes since the gains will accrue in your child’s name, not yours. Business owners can use this strategy to sell business interests to children with loan repayments made from company profits.