A friend told me the following story about his sister, who was a food nerd way before everyone you knew was. The sister, let's call her Emily, wanted to open a hip new ramen joint in her small city (she'd gotten hooked on a trip to Japan), and she bugged her father to lend her a substantial chunk of change ($100,000!) to get this dream off the ground.

She eventually wore their Dad down. Although her father put the deal in writing (really, just chicken scratch on the back of envelope) the deal was done with no official paperwork. Soon after, sadly, the dad passed away--with Emily having paid almost nothing back.

Now Emily is claiming that the money was a gift, not a loan--despite the note. It's a decent portion of her father's estate, so naturally her siblings want her to put it back in the inheritance pot. The resulting resentments have torn this once close family apart.

For parents, giving money to your kids is almost instinctual. And while many of you aren't considering loaning anything close to 100 grand to your children, a lot of you are giving them at least some money. A recent Pew survey found that 61% of U.S. parents said they'd helped their adult child out financially within the last 12 months. I get it. But there are reasons to be cautious about opening the vault of the Bank of Mom and Dad.

One recent survey, by the financial information site MyBankTracker.com, found that lending money to family or friends was at the top of people's list of biggest financial mistakes. Here's why: It's a financial transaction based on emotion. Money and love aren't the same things, but often the two get confused in family relationships.

Reasons to Say No

There are so many ways lending money to your offspring can go sideways. For starters, if you loan money to one kid and not another, prepare for jealousy and hurt feelings.

Another thing to consider: What if your kid wants to borrow money not to start a business or go to grad school, but to dig out of a hole created by bad financial decisions? Shielding him from dealing with the consequences isn't teaching him anything. In fact, you may just be perpetuating a cycle of debt.

Whether or not your kid is truly irresponsible, if you let her borrow money you may start to take her money choices personally. Unlike a bank lender, you'll get a chance to see the stuff your kid is spending money on while you're waiting to be paid back. If she's jetting off for vacation in Tulum or binging on Seamless, resentments could build.

As for your kid, he may come to feel that the loan is just an excuse for you to hold something over his head. Seriously, if he'd known you were going to bring it up every time he visits, he'd never have taken your lousy money.

If you really want to help your kid out, consider options other than a loan. Can she move home with you until she gets back on her feet financially? (If so, be sure and make sure each side knows what is expected of the other.) Is there a specific expense you can help out with (say, picking up your kid's cell phone bill or student loan payments for a few months), instead of just handing over money?

But If You Have No Choice...

Still, I understand that there may be times when lending to your kid is the best--or only--option. So if you're going to do it, at the very least make sure you do it right.

  • Don't lend money you can't afford to lose. This means no raiding of your retirement accounts, or otherwise putting your own financial well-being in jeopardy. Call it the airplane oxygen mask rule. You first, then your child.
  • Put the agreement in writing. It may feel weird to you to do this, but if you don't, you're relying on your respective memories as to what is owed and when it's due. You might be surprised at how often those memories won't match. It's not that either of you is being intentionally dishonest. You're just human.

Karen Altfest, a principal advisor with Altfest Personal Wealth Management in New York City, says that creating this agreement, known as a promissory note, is a protection for both you and your kids. "You want to be a parent to your children. You don't want to be going after them saying, 'You owe me a payment.'"

Any promissory note should include the following:

  • Date of agreement.
  • Names of parties.
  • Amount borrowed.
  • Interest rate, and how often it is to be paid. For amounts over $10,000, the IRS requires you to charge a minimum amount of interest, called the applicable federal rate--which is available at "Index of Applicable Federal Rates (AFR) Rulings" at IRS.gov. Right now, the minimum interest rate for loans that last three years or less is 1.04%, 2.10% for loans lasting three to nine years, and 2.81% for loans longer than nine years--hardly exorbitant.
  • Maturation date.
  • Schedule of payments.
  • Recourse for nonpayment.
  • Signatures.

Websites such as Nolo.com or the Internet Legal Research Group can help you draw one up. But if you are serious about crafting a legal document, Altfest recommends consulting a tax attorney, accountant, or financial planner.

One final thought: Making a no-strings-attached gift may not be possible for you financially. But if it is, and you feel that your kid will use it for something worthwhile, do that instead. You may find that there's joy and peace of mind in being your kid's parent, not her banker.

For more advice on talking to your kids about money, check out my new book Make Your Kid a Money Genius (Even If You're Not).

Published on: Feb 9, 2017
The opinions expressed here by Inc.com columnists are their own, not those of Inc.com.