By FPA member Eric S. Toya, CFP®
Last Updated: February 14, 2011
A few years ago, just about anyone could obtain a mortgage, regardless of credit score or income. It had been widely reported how well (or rather, not well) that turned out. As a reaction to the problems created by excessively easy credit standards, the pendulum has swung the other way. If you have applied for a mortgage for a purchase or attempted to refinance, you know how difficult the process has become.
Meanwhile you may have a family member, perhaps Mom and Dad, who are finding that the yield on their fixed income is not what it used to be. In fact, the short-term stuff, such as bank savings and money market accounts, might be closer to zero than one percent. They could increase their yield by buying longer-term bonds, junk bonds or emerging market debt, but that may involve more risk than they are bargaining for.
One possible solution to get the funding that you need and help Mom and Dad earn a better yield for some of their fixed income is an intra-family loan. Structured properly, Mom and Dad get a return on their funds that beat Certificate of Deposits (CDs) and other low-risk fixed-income investments. You get the loan that you need with a rate lower than current mortgage rates and without the hassle of qualifying under today’s tight underwriting standards.
Loans from parents to adult children are not a new idea. This is particularly true when it comes to helping adult children purchase a house. Often, loans are made privately, undocumented and without interest, or if interest is agreed upon it is, again, private and undocumented. If you plan to go the undocumented route, you should be aware of the pitfalls and risks.
First, if the loan is being made interest-free, the Internal Revenue Service (IRS) has a rule called “imputed interest” in which they essentially tax the lending family member for the amount of interest that they should have received. Also, interest that would have applied may be considered a gift, which could trigger gift taxes. As if problems with the IRS aren't bad enough, in the event of a family squabble or divorce, an undocumented intra-family loan may become a source of additional friction, whether between parent/lender and child/borrower, or even the child/borrower and siblings. Lastly, if the parents pass away during the life of the loan, an undocumented loan becomes a source of complication and potential conflict during the settlement of their estate.
A properly documented loan sets clear expectations around the amount and timing of repayment. It allows the borrower to deduct the interest paid as a mortgage interest deduction. Of course, the lending family member will have to pay income taxes on the interest earned. A properly documented mortgage includes filing a lien with the appropriate government authority and ensuring that the homeowner’s insurance recognizes the lien holder as an insured interest.
The interest rate that is charged for the loan is at the discretion of the family members involved, but the IRS does have some say in the matter. The IRS sets a base rate, updated each month, which represents the minimum that should be charged in an intra-family loan in order to avoid triggering gift taxes or other complications. This rate is called the Applicable Federal Rate (AFR). As of January 2011, the AFR on a loan with repayment terms of longer than nine years was 3.84 percent.
Of course, Mom and Dad may want to help, but the full amount of your mortgage just isn’t available to lend. More frequently, they may help with the down payment. This, too, may be formalized in a fully documented loan. According to Timothy Burke of National Family Mortgage, a company that specializes in documenting intra-family loans, “I think it's important to discourage lenders from bailing their kids out of trouble — as hard as it may be for them. Very few folks are aware that the Federal Housing Administration (FHA) actually allows borrowing your down payment from your parents, as opposed to a gift. This is probably a more realistic alternative for everyday folks considering a family loan to purchase a home.”
An attorney can help you draw up the contracts and the proper paperwork to formalize the loan. Alternatively, there are companies who specialize in formalizing and administering loans of this type. This may include payment collection, reporting to credit agencies and providing tax documents. A qualified financial planner will be able to help you determine if an intra-family loan makes sense for you and your family.
FPA member Eric S. Toya, CFP®, is Vice President of Wealth Management for Trovena, LLC. Toya graduated from the University of Southern California with a BS in Finance and Accounting.