What return should I require when guaranteeing a loan with my home?

Question

I put up my home as collateral for my son's business loan. What kind of return should I expect?

Answer 1

I put up my home as collateral for my son's business loan. What kind of return should I expect?

This is something that you needs to be determine before the transaction takes place.

If the business goes well, and all the loan payments are made, then you could decide to accept no money from your son.

But what they have done is put your house at risk, and made it impossible for you to sell the house until the business loan is paid off. You need to determine how much that is worth to you.

You need to get whatever terms you negotiate in writing. In fact you need a contract even if you aren't making money on the deal. You need to know what happens if payments are missed, you need to know what happens if he wants to refinance or extend the loan payments. You don't want to discover in year 5 of a 3 year loan, that they have been missing payments and foreclosure is next week.

By doing this type of financing you have an interest in the business. You need to know what benefits and risks that entails. You don't want to discover at a later time that you have even more of your resources at risk.

Answer 2

From personal experience, none whatsoever. Never guarantee for anything. Never, ever. If you have the money and are willing to lose it, give it to him. If you don’t have the money, or you don’t want to hand it over, keep it. Second hand personal experience fortunately, where the company actually was successful but the father almost lost his home.

Answer 3

That's not a good situation. Business and personal do not mix well.

If his business fails (or grinds along at subsistence level for years), what agreement have you made? Will you 'pull the plug'? What if he needs more money?

If he is struggling and cannot keep up payments, but will 'succeed any day now', what have you agreed upon to happen?

If you have to pull the plug on the business, might he blame you?

You could come out of this without a house and with a bad relationship with your son.

Answer 4

They're effectively borrowing the equity you have in your home, while the asset/home is still yours. This means that you can lose the house if the business fails and you can't repay this debt. In my view, a co-signed debt is also your debt. In this view, it doesn't matter if it is you or the business paying the debt. The debt must be paid by you, or by the return profits of the company.

• If you want to break even, as in, just pay off the debt, then the return of the business at minimum need to be the loan interest payments over the same timespan. The bank should be able to provide an amortization schedule and the total cost of the loan over X months/years to know what the business needs to pay towards the loan that your asset is collateral for. Loans cost money, so the repayment will obviously be more than the loan amount itself.

• If you wish to make money, it depends. If you wish to simply make a profit while doing something nice for your son, then the return simply needs to be above the minimum mentioned above. However, it gets complex if you’re wanting to make a competitive return. In that case, you have to look at similar returns of other investments of a similar risk profile and timeline, and be above that. This is tricky, because it kind of depends on what 'you' expect, from a personal perspective. Do you expect a competitive return? Do you expect a minor return since it is family? This is up to you, not us.

With that said. I started my own business a couple years back and I avoided as much as I could from needing loans. My goal was, in part, to avoid putting the money of family members at risk, if I were to require funds from others.

This type of an arrangement is awkward for you and him. He will likely have a lot of added pressure due to an important family asset being on the line… and you may inadvertently pressure him if things aren’t going as expected. When doing this arrangement, hopefully you considered the real possibility of losing your home. If you have and you’re fine with that possibility, I suppose all is good. However, as mentioned, it’s rough to merge personal life with business.

Lastly, it should be noted, the expected return should be agreed upon before co-signing. This type of expectation is a contractual agreement of sorts, your price for the loan, so to speak.

Answer 5

I hope that's a hypothetical question rather than your already having committed to it...

See other answers about co-signing loans. That is exactly what you are doing.

Can you afford to risk the loss if the venture doesn't out? Can you afford the loss in your own borrowing ability for the duration of the loan? Only you can evaluate the potential costs involved, but they are non-trivial.

Once you have established that, you can balance them against how much your son needs the assistance, how much it would cost him to borrow elsewhere, and how confident you are in his succeeding at least well enough, long enough, to pay you back. Remember that most new ventures take a while to pay back, if they do so at all. Against that balance your willingness to take some risk to help your son.

Once you understand the risks... Whether and how much interest you charge for accepting that risk is up to you.

I've done a formal "in-family mortgage", and the government required I charge at least some interest (0.3%, I think) and report that as income -- though the borrower gets to write off the interest against taxes. This is a very different case than yours, but it's one suggestion. (In my case I had the saved money to fund the loan, and the "reasonable" rate would have been that required to make up the loss in income from not having that money invested and earning returns -- around 8% -- but I was willing to consider that loss a gift.)

Or you can look at the fact that this might force you to eventually borrow money without the house as equity and hence at a high rate of interest, and charge up to what credit cards do.

Note that at higher rates, he may be better off seeking backing elsewhere, depending on how much he can convince other investors to believe in his plans. Which points out another option: rather than setting a specific interest rate, you can ask for a share of or partnership in his company, and take that percentage of whatever net profit he makes after costs and servicing the loan. You're acting as an angel investor, after all, even if not with currently spendable cash.

Remember that effectively he is borrowing part of the value of your house from you. It might be simpler to just lend him the money yourself.

This is a big business investment, despite the family component. Treat it as one. How much are you willing and able to risk, how much would you need to be offered to convince you that it really makes sense, and how much are you willing to consider a gift?

Answer 6

From an investing point of view, your loan can be divided into systemic risk and particular risk.

Systemic risk is the degree to which the risk of the loan is correlated with the market as a whole. This risk is measure by a quantity called "beta". Beta is what multiple of market risk your investment is. A beta of 1 means it has the same risk level as the rest of the market. A beta of 0.5 means it's half as risky. 3 means it's three times as risky. Etc. A fair return would be the return of the market in general times beta.

Particular risk is risk that is uncorrelated with the rest of the market. In a diverse portfolio, this is hedged away by one's other investments. But the larger a percentage of your portfolio an investment is, the more important particular risk is. For most people, the value of their house is a very large, quite often majority, portion of their net worth. So the particular risk likely drowns out the systemic risk.

If particular risk is a significant factor, then there isn't really any way of figuring out a fair return other than looking at what your personally would be indifferent to. That is, if were given a choice between a 100% chance of having the value of your home, or probability p of getting the value of your house plus, and probability 1-p of losing it, for what value of X would find those two options equally attractive? And of course you'll have to decide what you think p is.

All of the above is the financial analysis, but there's more to it than explicitly financial issues. There isn't just financial risk, but the risk of what it might do to your relationship if you invest and lose the money, or what it would do to to your relationship if you don't invest. Or perhaps if you lose the money, you'd still value showing your son that you're willing to support him.

Answer 7

I put up my home as collateral for my son's business loan.

As other have said, this is a risky move, as you are betting both your home and your relationship with your son on the success of a business that wasn't able to get a loan without collateral.

On the other hand, this is part of how generational wealth is built -- parents investing in the success of their children.

What kind of return should I expect?

It's not at all unreasonable to ask for an equity stake in the business, as you are shouldering most of the financial risk of a failure; the contract can be written so that your son can buy out your stake later out of the profits if the business succeeds.

Also, an equity stake may give you some say in how the assets are dispersed if the business goes bankrupt, as many new businesses do. It may be cleaner to simply take out a (second?) mortgage and lend the money to the new business yourself, which gives you standing as a creditor in any dissolution; that will also give you a baseline for a minimum rate of return to ask for.

In general, the riskier the investment, the higher the rate of return should be. How confident are you in your son's business plan? How confident are you that he has the skills and knowledge to run a successful business of this type? How saturated is the market for his product or service? How much of the startup money for his business is going to go to hard assets (for example, buying land for an organic farm, or equipment for an auto garage) and how much to running expenses (for example salaries and licensing fees)?

It's not uncommon for banks to ask for collateral for small business loans for new businesses, but can you afford to lose this collateral if the business goes under? Can your son commit to helping you pay off the debt if the business fails?