I've written before about some huge financial benefits that can be seen when multiple generations work closely together on financial matters. Recently, I had two related questions that I thought could combine into an excellent Q&A blog post.
Home Equity Loan To Pay For Medical School
I will be starting med school next year and my parents generously offered to take out a home equity 10 year loan to help me pay for school. Interest will be locked at 1.99% in year one and variable later on, but probably won't get higher or close to the federal loan rate. We would probably get 400,000, and I would be making interest payments monthly from the money I've saved working. We would also be using a line of credit. This sounds like a sweet deal to me, but is there any catch to this? I can't find enough info online to really know and was hoping I could get your advice. Thanks!
[Note: Further questioning revealed that the student expected to attend a school with a tuition bill of $40,000 per year and that the parents were planning on using some of the home equity loan for other purposes.]
Yes, it is a sweet deal (for you) and yes there is a catch. The catch is that this is probably a bad idea for your parents and I'm sure you care about their financial situation as much as you do yours. Here are a few thoughts to consider together with your parents when making this decision.
Students, Not Parents, Should Have Student Loans
I believe very strongly that if anyone needs to borrow money for an education, it should be the student. This is for several reasons.
First, if heaven forbid you die, your student loans go away. Home equity loans, however, do not go away with your death. So there is the possibility that you run up $300K in debt, then die, and they're still on the hook for the $300K.
Second, I think it's okay to take out a reasonable amount of debt for two things- your own graduate education and your home. Maybe some investment property if not too highly leveraged and a practice/small business loan to get started with your practice if there is no better way to bootstrap it. I really don't like going into debt for anything else. I think it's great to help your kids. I plan to help mine out with their educations. But I plan to do this by saving up for their education, and by paying for it out of cash flow. I won't be going into debt for them. Now, I don't know anything about your parents, but the fact that they've got to borrow money to do this tells me they don't have enough that they can eat a $300K loss without significant consequences. If they could afford to give you $400K for med school, I think that's great. But they can't, as evidenced by the fact that they have to borrow for it.
Third, when you take out the loans, you have more skin in the game. Read the economic outpatient care chapter in The Millionaire Next Door for more details.
Finally, a home equity loan doesn't have the same protections as a federal student loan. For example, if you don't match, like this lady, or if you end up with a very low paying career, you still have the possibility to limit your payments with the IBR/PAYE/REPAYE programs and to get rid of your debt at 10-25 years via the PSLF and other programs. It doesn't happen often, but it does happen.
The Bottom Line
I love the fact that your parents can access debt at a much cheaper rate than you can. I also love the fact that it is probably deductible for them, making it even cheaper. An effective after-tax rate of 1% sure beats paying 5-8%. However, there is some real risk there that I think needs to be taken into consideration. One effective way of eliminating much of that risk is to buy a term life policy on you equal to the debt and payable to your parents. It doesn't matter so much whether you or they pay the payments, but at least the debt still goes away if you die, and there is a large enough difference between 1% and 6% that you can pay life insurance premiums out of it. You might wish to get disability insurance for the same issue. But you can't insure against all the bad circumstances that can occur that would cause them to be stuck with the debt. So some risk will remain. If all parties are okay with running that risk, then there is definitely some money to be saved there. But I don't think I would recommend this approach.
The Private Annuity
Would you write an article about private family annuities? Say a reader’s parents are recently retired and now investing conservatively. Is there an easy way the child could invest the parents’ money aggressively (since the child has a lifetime to ride out the ups and downs of the stock market) and pay the parents a monthly amount on par or higher than their conservative returns? Similar to a SPIA where the child acts as the insurance company. That way no money sits in low-return investments and both parties come out on top. What are the benefits, risks, and drawbacks? Legal and tax considerations?
I love the outside the box thinking with this question. There's just one problem with something like this- the risk. The point of an annuity such as a SPIA is to take some risk (primarily that investments perform poorly and that you live a long time) and transfer it to an entity that is much more capable of handling that risk than you are.
Pooling of Risk
The reason that insurance companies can handle that risk better than you is not just that they are effectively younger than you. It is that they can spread the risk of you living a long time over thousands of other people so that on average, everyone dies at their life expectancy. They also have the ability to handle the risk of poor investment performance by virtue of the fact that they invest conservatively (and so can ride out the ups and downs of the stock market) not aggressively and have other sources of revenue. Plus, they are backed, at least partially, by state guaranty corporations in case they go out of business.
You are not an insurance company and cannot become an insurance company. You cannot spread longevity risk over thousands of people. You are not backed by a state guaranty corporation. So, while it is possible that two generations working together can outperform a SPIA, they do so by taking on more risk. If both parties are okay running that risk, it may work out well. But I don't think there is a free lunch there.
Legal and Tax Issues
As far as legal considerations, all you have to do is draw up a contract. It would say, I'm going to give you $500K, and you're going to pay me $3000 a month for the rest of my life. But the problem comes in when the contract cannot be enforced because there's no money due to death, disability, profligate spending, fraud, bad investments etc. Some of that can be protected against with additional life and disability insurance, but not all of it.
Tax-wise, you could do this informally by trying to stay within gift tax laws, but if this were a formal contract, you'd have to follow all applicable tax laws. The younger generation would have to pay for any gains and income from the investments, but should be able to deduct the payments as a business expense.
The Bottom Line
In short, I think this isn't a very good idea. However, I think a variation on it could be a pretty good idea. Many elderly people consider a reverse mortgage, a fee-laden product with a high profit margin and plenty of scam artists. I would much rather see a well-to-do younger family member that is going to inherit the house anyway provide the reverse mortgage. There is still some increased risk, but there is so much margin there and so much risk of getting ripped off that I think it could still work out well for both parties.
What do you think? Would you consider being on either end of a home equity loan to pay for medical school? What about a “private annuity” or “private reverse mortgage?” Why or why not? Comment below!