Terms to Agree on Before Arranging a Private or Family Mortgage

Even a loan from Mom and Dad shouldn't be treated casually. Discuss interest rate, penalties for nonpayment, and more.

If you’re buying a home, you’ll likely face less paperwork and fewer hurdles in obtaining a loan from a family member or friend than from a bank or other institutional lender—but this doesn’t mean it’s a casual transaction. At some point, for both your protection and your lender’s, you’ll want to commit the precise nature of your agreement to writing. (This will take the form of a “promissory note” as well as a mortgage or deed of trust.)

Many people’s eyes glaze over about now, thinking, “Ugh, legal contracts, can’t I just get some samples and sign them?” But contracts are just the pieces of paper upon which you write down what you’ve both agreed to.

And wouldn’t you like to have a voice in the various possibilities—what schedule you’ll make the payments on, what percentage interest you’ll pay, what happens if you can’t make a payment, and so forth? Once you’ve finalized your agreement, after all, you’re bound to an arrangement that may last decades.

This article will help you think through the important terms that will eventually go into the paperwork that you and your family lender will sign. It’s probably worth taking time to think on your own about how you’d like to see the agreement structured and what you think is fair for both you and your lender. Then have a discussion with your lender about what terms he or she will agree to.

Here’s a review of the most important matters to discuss.

Deciding on the Loan Amount

Any agreement that you sign will, of course, need to state the total amount that you’re borrowing. This will, in turn, depend on the home price. Make sure you discuss the maximum with your prospective lender before getting too far along on the path to buying a home!

It's also possible to divide the loan into two parts—one, a short-term, unsecured, non-mortgage loan (in other words, one that doesn't use the house as collateral) and one that's an actual mortgage, secured by the home, with regular repayments. This might, for instance, be appropriate if you've unexpectedly found a house you'd like to buy but can't sell your existing house right away and can't afford two mortgages at once. Once your current home sells, you will pay off the short-term loan. (Why would someone want to do this? Local tax law is often a driving reason; for example, New York state charges a mortgage-recording tax of over 2% of the home loan amount, so there's an incentive to keep that loan low.)

Determining the Loan Start Date

The date upon which the lender must actually provide the funds for the home purchase will also be stated in the paperwork. This will depend on the date you agree to close upon the house. If your family-or-friend lender has easy access to the funds, you may actually be able to set a closing date that’s sooner than the average buyer can pull of—a point in your favor, if the seller is eager to get the deal closed and move on.

Setting the Annual Interest Rate for Repayment

With any luck, your lender will offer you a below-market annual interest rate. A really generous lender might want to charge you zero or nominal interest—but that would create tax complications, as described in How Much Interest to Charge on Home Loan to Family Member.

For the sake of fairness, try to settle on a rate that not only passes IRS scrutiny, but that also takes into account how much the lender could be earning elsewhere, perhaps in a savings account or CD. It’s often possible to find an amount that meets or exceeds that while remaining lower than what you’d pay to a bank. Your loan agreement should clearly state the rate you agree upon.

Setting the Loan Term (How Long It Lasts)

Traditional bank loans run for 30 years (with lesser-used options at 20 and 15), but with a family lender, you can choose any term that suits both of your financial needs. Does 23 years sound good? Fine!

Consider both your and your lender's long- and short-terms financial goals here. If, for example, your lender plans to retire in five years, then you may be looking at wrapping up the loan during that time, perhaps with a plan of either selling or refinancing at the end of it.

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 any outstanding principal by a certain date. This gives you the benefit of low monthly payments before the final payment comes due, and gives your lender the benefit of knowing that you plan to pay off the loan within a short time frame.

Deciding Whether the Lender Should Have an Option to End the Arrangement

One way of easing a lender’s concerns about this major long-term obligation is to include what’s called a “demand clause” in your agreement. Such a clause 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 from the borrower’s perspective, either. 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.

Establishing What Happens If You Pay Late or Fail to Pay (Default)

If, at some point, you run into difficulties repaying the loan, your agreement with your lender should spell out the consequences. For instance, you might want to include a 15-day “grace period,” after which your payment is deemed “late” and you will 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 will have the right to foreclose on—that is, reclaim and sell the property—for repayment of the loan. 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.

What’s Next

After deciding these basics, you can turn over the task of creating the actual contract to an attorney or family-loan-servicing company, if you wish. (This is a sufficiently complex transaction that doing it without professional help isn’t a good idea.)

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