A loan within a family, or among friends, can be a great way to help a home buyer meet the financial requirements for the purchase – while also keeping the interest money within one’s personal circle. Given the level of trust and goodwill that typically exists before someone will agree to make a large loan to a family member or friend, the lenders often feel like perhaps they shouldn’t charge interest at all.
Charging at least some interest is usually important for legal and tax reasons, as described below. But how much, exactly? The best way to set the exact percentage is to consider:
- the lender’s competing investment opportunities
- what monthly payments the home buyer can afford, and
- the gift tax implications.
Setting an Interest Rate Higher Than the Competition
The home buyer is not the only one eager to pay interest for the use of the lender’s money. If the interest rate is too low, the lender would be better off keeping the money in its original investment vehicle. The buyer should offer a high enough rate to justify lending the money.
It often helps to create an interest rate comparison table. This is easily done by collecting current interest rates and yields on various investment vehicles from sources such as Bankrate.com and Bloomberg.com.
Setting an Interest Rate That the Buyer Can Afford
Calculate the planned loan at various interest rates and different repayment periods to determine a monthly payment that the buyer can afford. The easiest way to play with the numbers is by using the online calculator such as one of those at www.myfico.com (select “How much will my (fixed) mortgage payments be?” or “How much will my adjustable rate mortgage payments be?”).
Setting an Interest Rate High Enough to Distinguish the Loan From a Gift
A buyer who receives money from a relative, friend, or other private party, and pays back the loan without interest or at a rate lower than the minimum rate required by the federal government, will most likely be viewed by the IRS as having been “given” the uncharged interest money.
The minimum federal rate is called the “Applicable Federal Rate” or AFR. That’s no big deal unless the buyer should have paid the lender a whopping $14,000 or more in interest (the annual gift tax exclusion amount as of 2013 and extending through 2014). But if the lender was planning to separately give the home buyer $14,000 in the same year, this forgone interest might tip the lender over the annual gift tax exclusion. The inconvenient result would be that the lender would have to file a gift tax return, and the gift would be deducted from the lender’s lifetime estate and gift tax exclusion.
See “Borrowing From Family and Friends to Buy a House” for more information on arranging this type of mortgage loan.