There have been many books written on the family bank concept. Frankly, most of these were written to educate potential customers on the benefits of borrowing from the cash value portion of whole life insurance policies. I would like to provide a simpler perspective.
My family has implemented a simpler version of the family bank concept. We have an entity – I will get into entities and their value in an upcoming post! – in which we keep our financial assets. This consists mainly of brokerage accounts -some dividend-paying stock mutual funds and some cash-equivalent accounts. As I’ll explain in a later post, this is also the entity that holds other assets such as private real estate investment trusts (REITs), private real estate placements and our real estate and business lending accounts. Although it is starting to sound complicated, it’s really not. It’s where we keep our money.
We have assigned some important rules to this entity that holds our money. The first rule is no money comes out of it unless it is borrowed. We treat it as a bank. Granted it is owned by us – indirectly of course by you guessed it, by other entities. But doesn’t matter. It is only allowed to make loans with its money.
This is the simpler family bank concept. It is really nothing more than financial discipline. Any money that comes out as a loan is paid back WITH INTEREST. No exceptions. As an example, we recently paid off an auto loan. This is usually a good thing to do to avoid paying interest to an outside bank or credit union. However, instead of just spending the money and exposing ourselves to the opportunity cost of no longer having that money to invest elsewhere, we employed a little financial discipline. We continued to make the car payment to our own family bank. We treat that loan payoff as if it were borrowed from the family bank, so it needs to get paid back to the family bank. The family bank’s assets grow as a result.
For a business lending example, we have a nice little eBay side business called Teal Zebra, LLC. Recently, there was an opportunity to acquire an entire storage unit of inventory. The money could have been sourced from our savings or put on the company credit card. But those options expose us to either opportunity costs – reducing our savings – or to interest leadage – paying off the credit card. Instead, the family bank loaned the money required to make the inventory purchase. It was a loan for a 5-year term at 6% interest rate. Why would we go to the trouble of setting it up this way?
We wanted to buy that inventory. We expect a very healthy return on that investment. We could have invested the money into Teal Zebra to make the purchase, but we would have to figure out a tax efficient means to get our money back out. By lending the capital from the family bank, Teal Zebra will make tax deductible, expensed interest payments back to the family bank. The family bank will collect the original principle plus interest. The loan is an asset on the family bank’s books which means no opportunity cost loss, or not very much at a 6% rate. This was an example of a business loan from the family bank.
Let’s delve a little deeper into why I refer to it as a family bank. Although the two examples related above only involved the assets and entities of my wife and I, we have a wider definition of family. Our grown children are welcome to apply for a loan at our family bank, too. Why would we lend money to our children instead of simply giving it to them? For a couple of reasons. The first is financial discipline. We want to continue to provide real life examples of how to think about financial decision making. The second sounds greedy. We want to continue to grow our assets. But it’s not as bad as it sounds and leads to the real reason. Are you wondering why our children might want to borrow from the family bank? The reason should become obvious. The family bank will become their family bank one day. By borrowing from the family bank and paying interest, they are simply growing the asset that one day they will control. They will get the benefit of that recaptured interest that didn’t leak out to an outside bank or credit union. In fact, their children, our grandchildren, will also benefit. Hence, the reason we call it our family bank.
The mechanics of the family bank can be simplified further from requiring a separate entity. It can be a savings account or a money market account. Or even a brokerage account. The structure in the beginning matters a whole lot less than the rules. The rules are important. One must treat that designated funds as off limits except for lending. The loan applicants should be required to apply. The need or purpose for the funds should be discussed and evaluated. The ability of the borrower to pay back the loan should also be evaluated. The borrower should sign a loan agreement. Yes, really. This is all part of the financial discipline lesson.
For the mechanics of loan repayment, download an amortization schedule for the entire length of the loan. The easiest way to track the repayment progress is to check off each of the required payments when they are made. If you want to embrace this concept fully, you could be like me and use an online loan processor. The borrower can make the payments directly to them or setup automatic payments and they will record the progress on the loan. They will even charge late fees when necessary and make deposits directly bank to the family bank’s account. I use ZimpleMoney.com to do this for our borrowers.
I encourage you to not worry about the amount of funds required to start the family bank. Start with what you can. (Plant a Salary Seed! = shameless plug). Though you may not be able to make an entire car loan in the beginning, can you borrow the down payment? Can you lend a $1,000 toward a credit card balance? That’s in fact an excellent use of family bank funds. It reduces or eliminates high interest rate leakage to a bank, recapturing it for the benefit of future generations of the family. It also reinforces that credit cards should be used with caution. It can relieve the stress that comes with never gaining on that pesky credit card balance. Any amount that you can agree not to dip into, can be the starting bank balance.
The lesson is avoid paying interest to external banks, credit cards and credit unions when you can. Recapture that interest without incurring “opportunity costs” by becoming the lender. Most importantly, exercise financial discipline as a real-life teaching example for your family. Consider planting some of your salary seeds to grow your own family bank.
We look forward to learning more about wise financial planning.