I was reading an interesting article in Money magazine today about a venture capital firm that is seeking out students with large amounts of student debt who are likely to pay it back because of their income (think a doctor with $150,000 in debt but who has a $200,000 per year salary). The venture firm reasons that these former students are a good credit risk and therefore they can make a profit by refinancing these student loans at interest rates below the standards set by the government. They are therefore offering these students five and ten-year loans at rates between 3.5% and 8%, which is a few points lower than they are paying with their existing loan. Because the government-backed loans don’t offer any kind of break for these affluent former students because of their incomes, but there is no penalty for early repayment even due to refinancing into another loan, it makes sense for these former students to refinance. It is a win for them because they end up paying less in interest. It is a win for the investors because they get a higher interest rate than they could in other types of loans for the given level of risk they are taking. It is a loss for the taxpayers since this removes the good loans that are likely to be repaid with interest from the general pool of loans, meaning they’ll see a greater percentage of defaults and bigger losses in the pool of loans that remain. This will likely result in higher interest rates, which will only make the problem worse, both in terms of early pay-offs and defaults.
The refinance is being pitched to students at swanky dinners by the companies offering the loans. The firms are looking to go public soon. While this might seem like a good investment for individuals since it would allow you to get in on this lucrative way to generate income, it definitely comes with its pitfalls. While the big mortgage lenders such as the major banks and Lendingtree haven’t gotten into this market yet, there is no reason they couldn’t. It would be difficult for these small start-up firms to compete with the big boys that have access to a lot more capital, allowing them to possibly offer lower rates to the students. It is also possible that the government will respond as loan losses start to mount and those losses threaten to undue to public loan system. The government will not respond as they should by offering lower loan rates to the students going into more affluent fields, no longer making them pay a premium because they are thrown into a pool with students who will likely never repay their loans (think an individual with a French History degree from Harvard). Instead they would be expected to respond by simply changing the laws by writing the new loans with an early pay-off penalty or just outlawing refinancing entirely.
But there is an option that private investors who are at or near retirement age might consider, although a lot of consideration should be given. Such investors are looking for income, now that CD rates are essentially nothing. One option would be to offer to refinance the loan of a child or grandchild, or that of a family friend. Another possibility would be to find an individual interested in a private refinance through an online ad or an add in a college newspaper. This should be viewed as an alternative investment, meaning that it is risky and speculative, rather than a standard fixed-income investment like a bond, particularly if family members are involved. On the other hand, it is a way to both help a grandchild and help generate income for expenses at the same time. A win-win for both parties. Here are some things to consider before making the leap.
1. It must be clear that this is a loan, not a gift from Grandma. Loans to family members are always fraught with risk to the relationship. Turkey just doesn’t taste the same if you are eating Thanksgiving with your debtor or lender. Before agreeing to such a loan, a discussion should be held in which such issues are discussed. You should talk about terms of the loan, what will happen if the lendee falls on hard times and cannot repay the loan for a period of time, and make it clear that you need the income from the loan and that it will have real effects on you if the lendee defaults. Making the terms of the loan as short as possible – five years at most – should also be done. The discussion might also turn to lifestyle choices, such as buying a lavish home or taking expensive vacations while the loan is still outstanding. If it is difficult to discuss these things before the loan starts, imagine how difficult it will be when your children have stopped making payments but are taking the trip to Australia you cannot afford.
You should also draw up documents, making the terms of the loan clear. This will not only help firm up the terms in everyone’s minds, but also provide the documentation needed should your state or the Federal Government think you have made a gift, rather than a loan (see the next section).
2. You must charge interest
In addition to the risks to relationships, there are also tax implications, in that a loan may be seen (correctly) as a gift if there is no interest charged or if the interest rate is too low. While it is certainly fine to give your children or grandchildren a good deal in terms of interest rates, be sure to check with you accountants to make sure you will not end up owing gift tax to the government due to your generosity. If you don’t really need the money, you can always give it back in the form of a down-payment on their first home once the loan is repaid, again being careful not to violate any gift tax laws.
3. The funds should come from the speculative portion of your portfolio, not your critical funds.
While the goal of the loan for you is to create income, don’t think of it as a replacement for CDs, because the risk levels are far different. If your bank just decided to stop paying you for your CDs, you’d quickly take them to court. Would you do the same if your granddaughter decided to stop paying? If you did, do you think you’d have any sort fo relationship with her afterwards?
Any money loaned to individuals, especially family members, should be seen as venture capital. This should come from money where it will be great if it works out, but no great loss if it doesn’t. If you have $3 M in your savings, you can afford to make a $50,000 loan. If you have $1 M, a $50,000 loan may make the difference between eating in your eighties and not. If you don’t have the financial resources to lose the money, don’t make the loan.
4. Make sure it is really a win-win. Making a loan to a borrower who will not be able to pay it off (or have the character to pay it off) will not be a blessing to the lendee. If the person to whom you’re making the loan is trustworthy and of great character, making a loan should not be an issue and just keep some interest that would be going to a lending institution in the family. If they are not trustworthy and do not have the character to pay you back because “you’re just their father,” making a loan can be the first step towards a life of dependency and a delay in their gaining the financial skills they’ll need to prosper. Sometimes letting them go it on their own is the better choice.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.