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
Q.
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.]
A.
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.
Bonus points if you can name this national park
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
Q.
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?
A.
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
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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!
I agree with your responses above, but I would offer a couple of additional considerations.
For the question about an equity line of credit to pay for a loan, I certainly agree with everything you wrote. However, the one possibility that you didn’t discuss is that the parents can afford to pay for the loan outright, but are taking out the line of credit in order to keep their money invested, and to actually put more skin in the game for the student, rather than just paying for his education outright. In other words,they’re taking out the line of credit for the same reason you haven’t paid off your mortgage. In that case, and assuming that they make sure that the student has life insurance and disability insurance, this might be the better way to go. Your thoughts about PAYE and PSLF are definitely an issue worth thinking about. One scenario that might obviate these concerns would be for the student to take out the loans now, and then for his parents to pay them off for him during or after residency. The student could begin the repayment process then. That would give him the best of both worlds, and would also protect the parents against the unlikely possibility of his not matching. Also, once he’s a resident, he will qualify for a better disability policy which would further protect the parents.
As far as the annuity question is concerned, again, I agree with most of your post, but I think that the only real benefit of the annuity is protection against the sequence of returns risk. Personally, I think that almost everyone is better off without annuities, especially If you have a long enough time horizon, or enough money. If the payout would have been between 5 and 6%, or less, with no COL adjustments, this would be a great strategy.
The only real risk is to the parents, should the child suffer financial hardships of their own, or not invest properly, and end up keeping the money.
I think that the pooled risk benefits that the insurance company gets are more than offset by the low yields they get by investing in bonds. Kitces had a good article on ” longevity insurance” annuities, in which he concluded that you would be better off with index funds. I think that article would support investing vs annuities for almost everyone. In this case, there’s also the ongoing income from work that the child earns, i.e. human capital, which will support this strategy.
In my family, we did this as an informal arrangement, motivated primarily by the estate tax ( prior to the recent increases in the limits) where my mother gifted money to each child annually, but this money all went into separate Vanguard accounts, invested in the Total Market Index Funds, with the stipulation that the money was not to be withdrawn by us and was available to my parents if they needed it. Needless to say, this money has done a lot better than the money that they have reinvested into bonds and CDs, 2000 and 2008 notwithstanding. Fortunately, they haven’t needed that money and are unlikely to need it in the future.
In this case, the money could be put into an index fund in the parent’s names, with the child as the TOD beneficiary. Then the child can make monthly payments to the parents. The parents have some protection because they have control of the principle. The child has some protection, because he will get the index fund at the death of the parent, regardless of what any will or trust documents might say.
Consider how family relationships change when family members become creditors/debtors to each other. Debtors become slaves to their creditors. Creditors assume rights to direct debtors decisions. New spouses find incentives to demonize the creditor in-laws. Rare is the family to survive the strains.
Dave Ramsey agrees. Don’t put family relationships at risk.
http://www.deseretnews.com/article/865581473/Dont-put-family-relationships-at-risk-because-of-money.html?pg=all
Gifting—no strings attached — is superior for family preservation.
Related to JZ’s comment about gifting being superior–and not about the blog post topics–I actually think business owners (and people who own real estate) can often do quite a bit better than gifting… they can use family income splitting.
I.e., don’t give away $14K… rather pay a child or grandchild $14K or $20K or $50K. That becomes a deduction to giver thereby saving income taxes… the money is income to recipient probably at a low tax rate, but that income can also be sheltered with above the line or below the line deductions.
P.S. Apologies for going off topic.
Is getting someone else to pay for your medical school a good idea? Hell yes! The catch? Forever in guilt, parents somehow need the money one day, you somehow have to provide for them forever because they helped you out way back when. But that’s normal intra-family drama you’ll have anyway.
Economic outpatient care concerns are from the parents’ perspectives. I suppose you don’t want to let yourself become demotivated, but whenever someone else is willing to foot your bills…
Bigger concerns are logistics: 1) presumably this is a lump-sum loan – who gets to hold onto the money as tuition payments come due? Are the parents going to blow through it? Are you going to blow through it? 2) What are the specific payback terms? You need a written contract with your parents. 3) Student dies… well yeah, just get the parents to purchase a term life policy which is super cheap for a person in his or her 20s.
The Private Annuity thing, on the other hand, sounds completely and absolutely terrible. Agreed, somebody’s kid is not an insurance company. And privately reverse mortgaging your folks’ house is equally terrible. Inevitably they will run out of money and live forever, and family strife will ensue.
Families that give the kids an idea that parental wealth somehow already belongs to the next generation tend to be fraught with problems, anxiety, jealousy, anger, lawsuits, etc. Mom’s money belongs to mom until she either a) gives it away (in trust or otherwise) or b) dies. When things devolve into I owe you this, you owe me that, it gets terribly messy, and it is an extraordinary family who keeps everything straight and everyone happy.
Edit: I re-read and notice the parents’ home equity loan is a line of credit. That makes a lot more sense. Of course you let someone else give you the money 😉
Interesting ideas. Is that Death Valley National Park?
Petrified Forest National Park.
Winner winner, chicken dinner!
I graduated from medical school with about 110k in debt in 2011. My parents at that time offered me 20k for a new car or towards the loan. I kept the old clunker and the debt trimmed down to 90k. They then stated that they would pay off the loan with me to pay them the 90k at 0% interest rather than have the loans remain at 6.8%. I had a life insurance policy that was worth more than the loans so that protection was there. I then paid them about 1k/month through residency. After the three years were up and i started attendinghood, I paid them back aggressively and they were made whole within 4-5 months of me being an attending.
A lot of my friends were calculating the worth of IBR or taking jobs at nonprofits or clinics that underpaid them with the hopes of writing off the loans after 7 years (3 years having been done in residency). My job search involved me just taking the best offer (full on compensation in an acceptable area).
I was insanely thankful for what my parents did, namely in the thousands they saved me in interest and the freedom it gave me in the job hunt at the end of residency.
Good for you for doing the right thing and paying them back rapidly despite them offering you a low interest rate. Great parents, great kid. I agree with you that being debt free gives you a lot more options with career and life.
My parents paid for my entire education even though we were financially in lower middle class. Fact that education was much cheaper few decades ago helped. They never gave me a “gift” or a “loan” They gave me what ever I needed, including borrowing from relatives. I did my best to earn as much money I could earn to help and live as frugally as possible.
Ever since my first paycheck as a resident, and still after all these years, every month I give my parents money. No questions asked. It is for them to do whatever they want to do with it. I sleep well knowing that they did their best to support me and I have the ability to show my appreciation.
Before I got married, my wife knew with 100% certainty that portion of what I earn is ear marked for my parents. She knew that portion of my life insurance will go to my parent. For a while they were even partial beneficiary of my retirement funds.
Things have worked out well for my family, including my 3 adult kids.
I do agree with importance of having life and disability insurance. Beside ones own personal feelings and sense of obligation, the wild card is ones spouse and possibility of divorce which may impair your ability to show financial appreciation to people whom may have helped. pre-nep agreement or something like that may protect your desire to help the ones that you want to help
Interesting set-up. As long as the relationships are there, it can work out very well financially.
I gave my parents a de facto reverse mortgage (in the form of a recorded open-ended line of credit on their residence that was drafted by an attorney). Mother needed a home health aide 24 hours/day for 3 years; she didn’t have the cash to cover the cost, but did have equity in her home. I paid the home health aide and treated the payments as advances against her home. It worked out very well for all of us.
(Caveat: We drafted and recorded the documents more than 20 years ago. I am told there are now laws against doing this in some locations. So check with an attorney first.)