Borrowing From Family and Friends to Buy a House

Bob Hope once said, "A bank is a place that will lend you money if you can prove that you don't need it." That might explain why more and more prospective homebuyers are turning to loved ones, and even more distant members of their circle, for help with financing. If done right, tapping the "Bank of Family and Friends" can be financially lucrative for both you and the person lending you the money. As described below, you get the cash you need, they earn interest at a rate equal to or even higher than they could have gotten elsewhere; everyone wins.

How Do Private Home Loans Work?

A private home loan, also known as a private mortgage or an intrafamily mortgage, is not much different than one you'd get from a bank, credit union, or other institutional lender. Like with an institutional loan, you'd normally sign a contract and establish a schedule of monthly repayments with interest. Your private lender will hold a lien on your property and have the legal right to demand full payment on the outstanding balance if you fall behind in making payments.

Note, however, that unlike what was possible in the past, you'll probably need to find a private lender to fund you the entire amount of the home loan. Trying to combine a family-and-friend loan with a traditional bank loan can lead to the bank refusing to go forward, if you appear to be taking on more debt than you can handle.

A private lender can even foreclose if the borrower defaults on the loan. Few would go so far when dealing with a loved one, but there's an important reason to give them this right: so that if you get into financial trouble and another lender forecloses on you, your private lender won't be left in the cold.

Rest assured, the borrower has legal rights as well. For instance, your parents couldn't foreclose on your house just because you arrive late for their 50th wedding anniversary, and your best friend couldn't demand an early payoff in order to buy a new car.

How a Private Home Loan Helps the Borrower

By turning to parents, your favorite aunt or uncle, your in-laws, a brother or sister, or even your best friend or business colleague, you might gain the following:

• A below-market interest rate. Borrowing from a relative or friend can mean a lower-interest loan than you'd be able to find elsewhere. That's because you and your private lender will set the rate (subject to the IRS imputed-interest minimum described in Promissory Notes for Personal Loans to Family and Friends). Because of their personal relationship with the borrower, most private lenders are willing to accept a comparatively low interest rate.
• Flexibility in paying back the money. Your loan repayment terms can be negotiated between you and your private lender. That flexibility can allow you to arrange a loan with an unusual repayment schedule at the outset (such as interest-only payments for the first year) or to later temporarily pause payments due to unforeseen circumstances. Just don't get cavalier about this, or you might strain (or destroy) the relationship.
• Federal tax deductions. As with a loan from a bank, private loans allow you, if you itemize on your income taxes instead of taking the standard deduction, to benefit from the federal tax deduction for home loan interest paid.

How a Private Home Loan Helps the Lender

Whether it's a relative or a friend, your private lender stands to gain in a number of ways, such as:

• Achieving a better rate of return. Even without paying as much interest as you would pay to a bank, you can probably offer higher interest than the person could get on current investments available average folks without major risk.
• Generating a steady income stream. Private mortgages are ordinarily repaid over time as opposed to in one lump sum (unless, of course, you sell your house, at which point you'd have to pay off the private mortgage in full). By setting up and following a repayment schedule, your payments can become a steady income stream for your family-or-friend lender.

Preparing the Loan Paperwork

Once your private lender has agreed to loan you money to finance your home purchase, you'll want to handle the transaction almost as a bank would. This includes drafting and signing a written promissory note and supporting mortgage documents. It's a good idea, although not required, to draft a written repayment schedule as well.

• Promissory note. Also referred to as a mortgage note, this is a legally binding document signed by you, the borrower, saying that you promise to repay the loan under agreed-upon terms. These terms, including the interest rate, payment dates, and frequency of payment, should be spelled out in the note. The note should also describe any penalties that the lender can assess if you fall behind in repaying the loan, including requiring full payment prior to the end of the loan term.
• Mortgage or "deed of trust." The mortgage or deed of trust (depending on which state the property is located in) is a legal document that secures (provides collateral for) the promissory note. It says if you don't pay back the loan, plus all fees and interest, then your private lender can foreclose on your property and use the proceeds to pay off the loan. The mortgage or deed of trust lists the currently recognized owner and legal property description and describes the borrower's responsibility to: a) pay principal, interest, taxes, and insurance in a timely manner; b) maintain hazard insurance on the property; and c) adequately maintain the property. If you fail to comply with these requirements, your private lender can demand immediate, full payment of the loan balance.
• Repayment schedule. Although a written repayment schedule is not legally required, it's both a convenient and an important way to keep up good relations with your family-or-friend lender.

It's wise to get professional or legal help with this, particular if the loan won't be between immediate family members. Some family loans might fall under the federal Dodd-Frank Act, which is implemented by the Consumer Financial Protection Bureau and governs mortgage lenders.

After You Receive the Private Home Loan

With any luck, your income will remain stable, and you'll be organized about making the scheduled payments until either the loan is paid off or you can refinance with a traditional lender. However, unforeseen circumstances might arise, causing you to run short on cash. Whatever the problem, if it's a legitimate cause for you to be late with your payment, discuss it with your lender. Get in touch as soon as possible, and definitely before the payment comes due. Your lender will likely appreciate your honesty and might help by lowering your payments, temporarily freezing them, or forgiving some payments altogether.

That's the beauty of an intrafamily mortgage. Repayment is much more flexible than with a bank. Just make sure that you don't abuse your lender's trust. Save special requests for the true emergencies.

For a comprehensive guide to help you get the right house at the right price, get Nolo's Essential Guide to Buying Your First Home, by Ilona Bray and Ann O'Connell (Nolo).