Dear Dr. Don,
Our son, who plans on a career in medicine, is in his first year of residency. He owes $160,000 in federal Stafford student loans. On his resident salary, he can only afford to pay the interest of about $1,000 a month. After his fourth-year residency is completed, he will still owe $160,000 in principal having paid about $54,000 in interest. My wife and I would like to help him out by using our home equity line of credit of $100,000 on our primary residence at the current variable rate of 2.9 percent to help him pay down his Stafford loans.
Just to be clear, we did not co-sign his Stafford loans.
Do I understand it correctly in that my wife and I would still be the primary loan recipients and therefore have the ultimate responsibility for paying off the home equity loan? We would like our son to pay off the loan at the reduced rate by paying the bank directly. Or, he could pay us, and we in turn pay the bank. Probably the latter makes sense, in that my wife and I would have record of interest payments for tax deductions. We take it he would lose his interest deduction on this portion of his loans. But it still seems better than him paying 6.8 percent interest in total.
If we take out the home equity loan and mail the check to Stafford, is that considered a gift and would he be responsible for income taxes on the $100,000? Also, if something were to happen to our son, would it be wise for him or us to take out a term policy, us as beneficiaries, to pay off the loan? It just hurts us to see him pay $12,000 or more a year just in interest. He's not asking for help, but we would like to help him out.
-- Bob Backing
If you use your home equity line of credit, or HELOC, to pay off the majority of your son's student loans, the obligation to pay off the HELOC is yours, not your son's. Since your intent is to provide your son with a lower cost of financing, and not to repay his debt, then I see the best solution would have you draft a loan agreement with your son for $100,000. Under this arrangement, you loan your son $100,000 and he uses the proceeds of the loan to pay down his student loans. You are not gifting him the money, you're loaning him the money. You're not making his loan payment; he's using your loan to pay down his loans.
While he'll lose the tax deduction on the student loan interest, you would gain the mortgage interest deduction, which can be used on your income tax returns. As long as you charge him an interest rate that is at or over the applicable federal rate, or AFR, for the loan, there's no gift involved. You should structure the loan so he pays the 2.9 percent interest rate you owe on the HELOC and you should be above the AFR rate. The term and the structure of the loan determine the AFR. Since your HELOC is an adjustable-rate loan, you'd probably want to structure the loan to your son as an adjustable-rate loan as well. That protects you from the risk of rising interest rates on your HELOC. I'd suggest working with your tax professional to decide the best term and structure for the loan to your son.
The annual gift tax exclusion for the 2013 tax year is $14,000. If you and your wife split gifts, that's $28,000. The only gift to your son is if you charge a below-market interest rate on the loan, or if you decide to forgive part of the loan.
Insuring your son and yourselves against the possibility of dying while either the HELOC or his loan are outstanding can provide you with a degree of comfort that the loans won't be a burden on the survivors. Because you are reducing his interest rate from 6.8 percent to 2.9 percent, at least initially, and you must pay income tax on the interest income, there should be a full discussion about who pays the cost of insuring the two loans.
Thanks to attorney Kirk Friedland for his help in answering this reader's question.
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