For many home buyers especially first-timers, a loan from a friend or family member can make all the difference. But how does one best sort out the financial and other complexities of an intrafamily mortgage arrangement? You'll find answers below.
My wife and I are planning to buy our first home. While I have a job, the pay isn’t great, and no bank will lend me enough to afford a home that fits our growing family. (Twins are on the way!) My wife won’t be working after the babies arrive, either. Fortunately, my parents have been disappointed by how their other investments are performing, and are happy to lend us the full amount needed to buy, at a modest interest rate.
Here’s the issue: We live in a competitive real estate market, where we face bidding wars with other buyers. I think we’re in a strong position, given that we can waive the financing contingency, but it seems like home sellers all want a mortgage preapproval letter from a bank—and we don’t have one. What can we do?
A home purchase offer that comes without a financing contingency should indeed be attractive to home sellers. Even buyers who come with preapproval letters from banks must still jump through a lot of hoops in order to get final lender approval, and the deal can fall apart from the last minute.
If you waive the financing contingency, then you are in effect saying that you have no doubt your parents will come through with the money—or that if they don’t, your pulling out of the deal would be a breach of contract, and you’d forego whatever amount you put down as earnest money.
It’s true, however, that home sellers will want something that serves as the equivalent to a mortgage preapproval letter. Their bottom-line concern is, “Can this buyer really come up with the money to close the deal?” They prefer the deal to go through rather than to keep earnest money and practically start over.
Fortunately, you’re not the first to face this dilemma. Others have successfully bought homes using family financing, typically by some combination of the following:
Providing a letter from Mom and Dad (or whoever their lender is) or from their financial planner or adviser confirming that they really do intend (and are in a position) to provide financing for the home purchase.
Providing copies of recent bank statements verifying that the lender possesses the funds, and that the money is in liquid form (in other words, easily available and converted to cash).
Offering to have the family lender deposit the funds in a neutral escrow account managed by an appropriate third party. This could be, for example, at your real estate agent’s office, with a title or escrow company, or with an attorney.
There’s no need to feel like you’re in a weaker position than other buyers. With a loan from parents, you are almost offering an all-cash offer, which should delight any home seller—it’s just that you’re one (very short) step away from the cash.
My grandparents have agreed to lend us money to buy a house with, but want us to pay it back when they retire in a few years. What are our options for setting the loan term?
Although traditional bank loans run for 30 years (with lesser-used options at 20 and 15), with a family lender, you can choose any term that suits both of your financial needs. Does seven years sound good? Fine!
You're wise to consider both your and your lender's long- and short-terms financial goals here. If, for example, your grandparents plan to retire in five years, then wrapping up the loan during that time could work, perhaps with a plan of either selling your home or refinancing with a traditional lender at the end of that.
Paying the same amount every month isn’t your only option, either. For example, you could amortize your payment schedule so that your monthly payments are the same as they would be over a 30-year term; but include a "balloon" payment after a limited number of years, requiring you to pay off the remaining outstanding principal by a certain date.
This gives you the benefit of low monthly payments before the final payment comes due, and gives your family lenders the benefit of knowing that you plan to pay off the loan within a short time frame.
It's not uncommon, as a way of easing a family lender’s concerns about this major long-term obligation, to include what’s called a “demand clause” in the agreement. This grants the lender the ability to "demand" that you, the borrower, repay the outstanding principal within 60, 90, or 120 days. For a lender who doesn’t know when it might seriously need the money, this is a good option.
It’s not as Draconian as it sounds. The minimum two months’ notice period should give you enough time to obtain bank financing. By then, you will hopefully have built up some equity in the house and strengthened your credit rating, so as to qualify for the most favorable loan terms.
I'm worried that, at some point, I might lose my job or run into other difficulties repaying the loan to my parents. But even they don't want the power to ruin my life over it! What's a good way to address this issue?
Your agreement with your lender should definitely spell out some consequences for nonpayment or other default. For instance, you might want to include a 15-day “grace period,” after which your payment is deemed “late” and you owe a late fee. Your lender might also want to add a late-payment penalty, perhaps between 1% and 4% of your regular payment amount.
What about situations where you aren’t just a few days late, but default entirely? As with a bank loan, your lender should have the right to foreclose on—that is, reclaim and sell the property—for repayment. Few family lenders will resort to this, most of them preferring to forgive payments (which become “gifts,” in tax terms) or restructure the loan.
Nevertheless, foreclosure is an important protection to preserve for your lender; especially because, if you get into deep financial trouble, other creditors may place liens on your home, and you wouldn’t want them to be first in line, ahead of your family lender.
I loaned my son over $300,000 with which to buy a home. He recently lost his biggest client, and couldn’t make last month’s payment to me. We’re past the grace period. I know it’s not his fault, and I really don’t want to foreclose. Then again, I want to get our agreement back on track (we signed a formal promissory note), and keep my own finances clear. (If I just let this go without acting, will the IRS think I’m making gifts to him?)
Do I have any good options here? Will this require scrapping the old promissory note and signing a whole new one?
You’re wise to try to handle this in a structured way, for the sake of your tax and other financial concerns and your son’s. And yes, you’re right that at some point, forgiven payments are going to look to the IRS like you’re making gifts to your son, and you’d need to file a gift tax return if your total gifts exceeded that year’s exclusion ($15,000 in 2018).
Fortunately, you do have some options for dealing with your son’s nonpayment, likely even without having to prepare a new promissory note, as follows:
You could, as discussed just above, go ahead and forgive the missed payment completely, in other words, make a gift of the amount of the payment. (Filing a gift tax return if the total exceeds the exclusion is a hassle for you, but it doesn’t mean you’ll actually owe the IRS money.)
You could agree that your son will double up the payment in a later month.
You could postpone your entire payment schedule for an agreed-upon period, until your son is able to stabilize his financial situation and get back on track with the payment schedule.
You could have your son add the payment to the end of the loan term.
No matter which of these options you choose, it’s a good idea to commit your agreement to writing. It's also worth charging interest, if it’s allowed under your contract (1%, for example), to show the IRS that there are consequence for default and therefore it isn’t a gift. You could, however, potentially gift the amount of the penalty to your son and have him turn around and pay it to you; talk to a tax adviser for a full analysis.
If none of those options look attractive, you could completely restructure the payment schedule, for example turning it from an amortized loan to interest-only. For this, however, you’ll need to write up a new promissory note.