I’m amazed at how many times clients tell me that they loaned money to one of their children and now they want to somehow add that into their estate plan.  I ask them if it was a loan or a gift.  They of course say that it was a loan, but have absolutely no paperwork to show that, nor has the child paid any of the money back.

Now I’m not saying that you shouldn’t give your kids any money.  In today’s economy, it’s hard for young people to make ends meet.  But if your child asks you for a loan, don’t pull out your checkbook until you’ve examined the financial and emotional costs.

When you go to a bank to get a loan for a car or a house, they specifically want to know what the loan is for, and you should too.  Like any lender, you need to decide whether the loan purpose is reasonable.  If your child is a chronic borrower, frequently overspends, or wants to use the money you’re lending to pay past due bills, be careful.  You might be enabling her to continue making poor financial decisions.  On the other hand, if she is usually responsible and needs the money for a purpose you support, you may feel better about agreeing to the loan.

It’s natural to want to help your child, but there are many things to consider, and financial independence should be a big one for both of you.  If you step in to help, will your child lean on you the next time too?  No matter how well intentioned you are, you can’t keep protecting your child from financial struggles.  Hopefully he will get to experience the satisfaction of successfully getting through a difficult financial time on his own.

And remember, your financial independence is just as important.  Perhaps you can afford to lend money right now, but look ahead a bit.  What will happen if you find yourself in unexpected financial circumstances before the loan is repaid?  If you’re loaning a significant sum and you’re close to retirement, will you have the opportunity to make up the amount?  If you decide to loan your child money, be sure it’s an amount that you could afford to lose and don’t take money from your retirement account.  You don’t want to add taxes on top of the loan.

You also need to think like a loan officer.  A gift is a gift, but a loan needs to be documented.  Putting loan terms in writing sounds too businesslike to some parents, but doing so can help set expectations.  You can draft a simple loan that spells out the loan amount, the interest rate, and a repayment schedule.  Try to steer clear of deferred or balloon payments.  You want to avoid changing from a parent to a debt collector.  Consider asking your child to set up automatic monthly transfers from his or her checking account to yours.

Having loan documentation is also necessary to meet Medicaid requirements.  In the eyes of the Department of Social Services, the rule is simple: it’s a gift unless you can show otherwise.  That not only means that there was actually a loan or promissory note signed, but that there is actual, consistent repayment.  If there is a deferral or balloon payment, they consider it a gift and may cause a period of ineligibility for government medical assistance for up to the next five years.  That’s something you probably want to avoid.

Another potential downside to loaning your child money is the family tension it may cause.  When you loan money to a relative, it’s personal.  If expectations aren’t met, relationships with your child and between the siblings may be at risk.  Will you be okay with forgiving the loan if your child is unable to pay it back?  And how will other family members react?  Will other children feel as though you’re playing favorites?

Relations become very strained when their inheritance is involved.  The child thought it was a gift and was forgiven whereas his siblings thought that it was still a loan and should come out of a portion of the inheritance.  Or do you try to “even it up” in your estate planning documents?  That’s another tricky area that’s fodder for another whole article.

If you decide to say no, consider offering other types of help.  Your support matters to your child, even if it doesn’t come in the form of a loan.  For example, you might consider making a smaller, no strings attached gift to your child that doesn’t have to be repaid, or offer to pay a bill or two for a short period of time.

Don’t feel guilty. If you have serious reservations about making the loan, don’t. Remember, your financial stability is just as important as your child’s and a healthy relationship between you, your child, and the siblings is something that money can’t buy.