Some people might not want—or be able to obtain—a traditional loan from a bank with which to purchase a home. A loan within a family, or among friends, can be a helpful way for such a homebuyer to meet the financial requirements for the purchase. This sort of arrangement has the benefit of keeping the interest money within one’s personal circle, too. Such a loan raises the question: Should there be any interest charged at all, and if so, how much?
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, such lenders can feel reluctant to charge interest. However, charging at least some interest is usually important for legal and tax reasons, as described below. Deciding upon the precise interest rate requires consideration of several factors, including:
As a matter of fairness, the buyer should offer a high enough rate to justify lending the money. The homebuyer is not the only one eager to pay interest for 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.
In order to name a fair rate, it is critical for the buyer and seller to at least begin with a baseline understanding of prevailing market interest rates. It can help 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.
Calculate the planned loan at various interest rates and different repayment periods to determine a monthly payment that the buyer can actually afford. If the selected rate is too high, the buyer might default, creating unnecessary tension within a close network of friends and family.
The easiest way to play with the numbers to determine actual monthly payments in dollar terms is by using an online calculator such as one of those at MyFico.com.
A buyer who receives money from a relative, friend, or other private party, and pays it back without interest or at a rate lower than the minimum rate required by the federal government, will most likely be viewed by the Internal Revenue Service (IRS) as having been “given” the uncharged interest money.
The minimum federal rate is called the “Applicable Federal Rate” or AFR. That is not a problem unless the buyer should have paid the lender a whopping $15,000 or more in interest (the annual IRS gift tax exclusion amount as of 2020).
But if the lender was planning to separately give the home buyer $15,000 in the same year, this foregone 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.
The AFR is set by the U.S. Treasury Department on a monthly basis, and can be viewed on the Index of Applicable Federal Rates (AFR) Rulings page of the IRS website.
For more information, see Borrowing From Family and Friends to Buy a House, which discusses arranging this type of mortgage loan.