The concept of a “trust” is not well understood by most in finance, yet most people will encounter these oddities a few times in their career. So what exactly is a trust?
A trust typically comes into existence by means of a trust agreement. The trust is formed for several reasons, but they are generally created so one person’s assets can be protected or managed by a third party. Why would someone want that arrangement?
Imagine your parents hit the lottery, and they wish to share the wealth with the entire family. But, we all have that one family member who is financially inept. We know if he/she got a cut of the winnings, they would manage to spend it all within a year, and not on wise investments either.
Just for example, let’s say we have a sibling named Jack. Here a trust becomes very useful for taking care of Jack. The money due to Jack can be put in a trust, but then be managed by mom and dad, another sibling, or even a family friend. The person who transfers money into the trust is called the grantor. The person responsible for managing Jack’s money in the trust is called a trustee; whereas, Jack is considered the beneficiary. No matter what crazy scheme Jack may come up with to spend the money, he won’t be able to do so without the trustee agreeing to it, and the trustee will follow the terms laid out in the trust agreement.
Trust agreements exist for several reasons. They are not just a tool to protect the financially irresponsible from themselves. The principle reason a person establishes a trust is because he/she has specific wishes or desired outcomes. Perhaps they want the money in the trust only to be used for education of their children or to help them buy a home. Another reason people form trusts is to grant their children an inheritance at a lower tax rate, or with no taxes; which is the case in South Dakota. When someone is elected the President of the United States, they are expected to turn over all their assets to a trust, so that any of their actions cannot be seen as a deliberate effort to enrich themselves.
In the examples above, we are discussing situations in which the beneficiary does not have control of the assets, because a trustee has independent control. This is what is typically referred to as an irrevocable trust. In this arrangement, the beneficiary does not control the assets, and they don’t have the ability to pledge or manage the assets. When doing credit analysis, this means the trust does not really contribute to the net worth of the beneficiary, unless the trustee is willing to allow the trust to guarantee the loan too.
In contrast, a revocable trust is a situation in which the grantor retains control of the assets in the trust, and they are the beneficiary, so long as they are living. Therefore, creditors have full recourse to assets in a revocable trust, although it is still beneficial to review the trust document to make sure it is, indeed, a revocable trust. The typical purpose for establishing a revocable trust is to avoid probate, thereby keeping details about grantors’ estate confidential when he/she passes away.
Trusts can be borrowers and guarantors, but you do need to be careful with the documentation. It is important you understand the difference between a revocable trust and irrevocable trust, and how that indicates who should be signing on behalf of the trust!