Friday, October 9, 2009

Paying off child's debt strains family ties

It involves money and emotions, dollars and sense

By Sarah Angle

(Editor's note: The names of Jeff, Patricia, and Eric Banks have been changed to protect the privacy of the family we interviewed.)

When Jeff and Patricia Banks paid off their son's $6,000 credit card debt, they thought they were doing him a favor. Paying off child's debt has strains family ties

Their 24-year-old son Eric was paying the card's minimum balance each month at a hefty 22 percent interest rate. So, instead of paying a credit card company, he would pay back Mom and Dad, save himself a huge chunk of change in interest, and become a financially smart, stable adult.

That was the theory. Unfortunately, when it comes to family and finance, things don't always work out as planned. When parents think about whether to bail out a child from debt, more than money is at stake. Says psychotherapist and co-author of "The Financially Intelligent Parent," Dr. Eileen Gallo. "It's never a cut and dried answer ... you have to look at the situation."

Helping versus hurting
Gallo says that when deciding whether to bail a child out of debt, the first question parents should ask themselves is: "Will this action foster my child's independence or extend their dependence?"

As a parent, your goal is to provide your children with the skills they need to grow into successful, responsible, happy adults, right? So, Gallo asks, what is your action teaching your child? "If parents continually rescue their kids, they are helping them stay dependent." If you're going to help, Gallo says, make sure it's real help -- which means evaluating the child's financial history and asking why they're in debt to start with. When you can answer the "why?" question, you'll begin to understand where this behavior is coming from and if paying off the debt is really in the child's best interest.

Do they qualify for a loan?
There are many emotions involved when it comes to family and finances, says Charles Schwab financial consultant Richard Rosso, so it helps to look at the loan from a more analytical perspective. Rosso recommends taking these steps before signing over a check:

Step 1: Evaluate the child's past financial history. Was the child responsible with money growing up? Was he or she a saver or a spender?

Step 2: Write down a list of questions you want to ask the child. Think about the type of questions a lender asks before awarding a loan, such as job history, additional outstanding debts, collateral and savings.

Step 3: Write down the child's answers to your questions and use those answers to help formulate your lending decision.

Step 4: Have the child make a detailed budget (or give you a copy of one if it already exists).

Sign on the dotted line, Junior
Now that you've got something to work with (other than pure parental emotion!) you're ready to make an educated decision.

At this point, if your head and heart are screaming, "Yes, I do want to help my baby out of debt!" just remember the devil is in the details. Before you even think about writing a check, set up a clear -- no questions asked -- set of guidelines to ensure that you and your child know what's what.

North Carolina financial consultant Beth Gregg suggests signing a parent-child contract. The contract should list clear payment due dates and monthly payments. It should also address the consequences of not paying or paying late.

What about interest? If you do decide to charge it, Gregg says, have it written into the agreement. To avoid having the IRS consider the loan as a gift, charge, at a minimum, what the IRS calls the Applicable Federal Rate. To find that rate, go to the IRS Web site, search for "applicable federal rate" and click on the first link. Table 1 contains the loan rate you need -- select the one that matches the length of your loan.

Family + money = messy
Asked later if he was glad his parents paid off his credit card debt, Eric hesitates. "It was good, in a way," he says. "At the time it seemed like a good deal. But now, thinking back, it wasn't such a good choice."

Owing his parents money makes things awkward, says Eric. "The only time I really feel comfortable hanging out with them is at the first of the month -- when we've paid off everything and we're caught up. If it's at the end of the month, Dad always brings up money."

"You can ruin a family over money," says Gregg. "Because it's never just a business decision, and a lot of times not everything works out as planned."

Case in point: Eric. Besides straining his family relationships, he's still overspending, not saving and relying on the generosity of his parents to make his life work. To add fuel to the fire, Eric's wife has chosen not to work. So Jeff and Patricia don't feel like the couple is doing all they can to repay the debt. The family's problem: There were no initial guidelines set up between Eric and his parents. So now there are no clear expectations or rules to follow.

We know this type of financial situation can affect the relationship between parent and child, but according to Rosso, it can affect the dynamics of the entire family. "When a parent loans money to a financially irresponsible child, it can create animosity between other children in the family," explains Rosso. "Siblings who aren't getting a bailout may feel that Mom and Dad are being taken advantage of. They empathize with the parents and have animosity towards the brother or sister getting the loan."

Keep an eye on your retirement
Most parents have an innate tendency to put their children first, and finances are no exception. As sweet and selfless as that may be, it can come back to hurt you and your retirement.

"Parents need a real black-and-white picture of how much money they need to live on before offering to pay off a child's debt," says Gregg. "You sacrifice so much for your kids and then say, 'My gosh, I can't do what I want to do after working for 40 years.'"

Jeff Banks says the $6,000 they used to pay off Eric's credit card didn't really hurt them financially. And looking back, he says he would still do it again. "But I would hope for a better outcome ... that Eric would have stayed in the clear and not messed up his credit. But in the overall perspective of giving things to your kids, $6,000 isn't a big deal."