Rethinking the bank of mum and dad

Following the 12^th successive interest rate rise by the Bank of England, there are going to be winners and losers – often within the same family.

You may be wondering what I mean – well, let’s take a closer look…

For the first time in 15 years, mum and dad’s cash in the bank is finally getting a bit of interest. But daughter, on the other hand, is quivering at the sight of mortgage rates she’s only ever heard stories about. However, if families work together where possible, significant benefits can be achieved.

Example:

If we consider a hypothetical situation with the above family, where everyone holds all of their financial arrangements with Big Bank Plc. The interest rates assumed are not untypical of those available today, although actual market rates can vary significantly and are subject to change.

Mum and dad

• £30,000 – Instant access cash account (interest rate 3.50% p.a.)
• £50,000 – Maturing long-term deposit which they are thinking of tying up for another 3 years (interest rate 4.5% p.a.)

Daughter

• £270,000 – Mortgage – fixed rate due to expire in 6 months with 90% loan to value (LTV) based on a property value of £300,000. She has been offered a 2-year tracker mortgage (interest 5.5% p.a. = £14,850).
• £10,000 – Credit card (interest rate 25% p.a. = £2,500).
• £10,000 – Car loan (interest rate 6% p.a. = £600).

My observation is that the parents are about to deposit money for another 3 years with Big Bank Plc to receive interest of 4% p.a.

That same money is effectively being loaned by the bank to their daughter to whom they will be charging interest (between 5.5% and 25%). Thus, Big Bank Plc is making a huge profit acting as the middleman for the same family.

So, what if we did something differently and cut out the middleman? What if the parents decided to lend £50,000 directly to their daughter, charging 4.5% interest?

Credit card – £10,000:

• Their daughter could repay her credit card debt with her parent’s loan.
• The interest payments would drop from £2,500 with Big Bank Plc to just £450 with her parents – a saving of £2,050 p.a.
• She could then arrange a payment plan with her parents with a term agreed at outset e.g. five years.

Car loan – £10,000:

• The car loan could also be repaid.
• The interest payments would drop from £600 to £450 with her parent’s loan – a saving of £150.
• The repayments to her parents could be structured over the same time period as the credit card.

Mortgage – £30,000:

• The remaining £30,000 could be used to reduce the mortgage, this is actually where the greatest difference is made as the loan reduces their daughter’s borrowing from 90% LTV to 80% LTV, allowing her to refinance at a reduced rate of 4.5% p.a.
• Interest on the £30,000 loan to the parents is £1,350 (4.5%) and the interest on the reduced mortgage of £240,000 is £10,800 (4.5%), compared to the 90% LTV tracker mortgage at £14,850 – a saving of £4,050 in one year.
• The interest payable to the bank will reduce in subsequent years as regular capital repayments reduce the value of the loan.

Total interest saving – £6,200:

We can see from the table above what savings can be achieved and mum and dad are no worse off than tying it up with Big Bank Plc for 3 years – win/win.

Maximise the savings

Furthermore, some of this annual interest saving could then be directed into a savings or investment vehicle (e.g. an ISA) for the daughter. Alternatively, she could contribute the total saving to a pension and receive at least 20% tax relief immediately. Put another way, instead of £6,250 being paid to Big Bank Plc, the daughter could walk away with £7,812 towards her longer-term financial security – a no-brainer really.

It’s truly amazing how much more families can achieve with their money when they work together. If this hypothetical scenario is a familiar one, speak to your adviser or, better yet, your family!

If you have any further questions, please don’t hesitate to contact us. If you’re a client you can reach us on 0161 486 2250 or by getting in touch with your usual Equilibrium contact. For all new enquiries please call 0161 383 3335.

The example used here is simply to illustrate the financial benefits of looking at the circumstances of a family collectively and does not constitute financial advice. 

When considering such strategies it is important to check whether any penalties apply on early repayment of any debt and obtain professional help. 

It is equally important to understand the implications of making gifts from capital to the next generation.

Equilibrium is not authorised to provide advice on debt counselling, but we can refer you to a professional partner should this be needed.