In the ongoing difficult borrowing environment, some potential homebuyers have found the best way to finance a purchase is not from a major commercial bank, but from the “family bank” instead.
As long as IRS guidelines are followed, the transaction can be remarkably appealing, with more flexible lending terms, IRS-required Applicable Federal Rates that are still lower than commercial mortgage rates, the potential to still deduct mortgage interest payments for the borrower, avoidance of origination and many other mortgage transaction fees, and the simple benefit that all the interest and principal payments ultimately stay in the family.
A major downside, however, is that to ensure the IRS truly respects the transaction – and to receive some of the tax benefits as well – formalities of the loan should be honored, including drafting a promissory note, recording the mortgage against the residence in the proper jurisdiction, and completing actual payments of interest and/or principal.
The basic principle of an intra-family loan is fairly straightforward – rather than borrowing money from a bank, a family member in need borrows money from someone else in the family, such as a child borrowing money from his/her parents. The benefits of doing so are significant: the interest costs paid by the child stay in the family (to be used by the parents or in the extreme, inherited back by the child in the future!); origination and other transaction fees may be avoided; the borrowing cost for the child is typically much lower than interest rates from the bank; yet (especially in today’s environment) the interest rate paid is still better than what the parents may have been able to earn from a bond portfolio.
For instance, in today’s marketplace, the parents could loan money to the child for a 30-year mortgage at 2.5%, which is much less expensive than a 30-year fixed rate mortgage at 3.5% (or higher, depending on loan-to-value, the size of the loan, and the borrower’s credit score). Yet the parents still generate interest at 2.5%; while meager, that’s better than what they’ll likely get from CDs (although notably, lending money out as a mortgage is a far less liquid for the lender!). In addition, if the loan is a mortgage that is actually secured to the residence the child purchases and is properly recorded, the child can still deduct the mortgage interest paid to the parents! (Of course, the parents will have to report the interest received on their tax return, just like any other “bond” interest.) And the loan can be structured as interest-only to reduce the cash flow obligations to the child (although obviously not amortizing the loan principal decreases the cash flow payments to the parents as well).
An added benefit of intra-family loans, especially as a mortgage for purchasing a residence, is that some of the constraints of traditional loan underwriting are no longer an issue; for instance, family members don’t have to charge more for a child with a bad credit score, and can freely provide loans up to 100% of the purchase price without requiring a down payment. The loan could be for a primary purchase, or a refinance, or a renovation, and can even be structured as a 2nd or 3rd lien against the house. One popular strategy is for children to borrow up to 80% using a traditional mortgage for a new home purchase, but borrow money from parents to fund the downpayment for the remaining 20% (recorded as a second lien on the residence).