What’s an Intra-Family Loan? (and Is It a Good Idea?)

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It’s a nasty situation for everyone.

Mom and Dad earn next to nothing on their cash and short-term bonds, and their kids want to buy a home but can’t afford the high down payment the banks want, or can’t qualify for a mortgage for some other reason.

Solution: an intra-family loan, often touted as a win-win for both parties. In an ideal arrangement, the kids would get the loan they otherwise could not, and save on the closing and other costs, while the parents earn, say 3% or 4%—not bad when a five-year certificate of deposit offers a measly 1.1%.

For icing on the cake, the kids still get the federal income tax deduction they’d get with an ordinary mortgage, and the arrangement keeps money in the family. The kids pay interest to the parents, who can spend it or keep it in their estates to pass back to the kids later.

So, if it’s such a great strategy, why isn’t everyone using it?

Many parents don’t have the money, or worry about putting it at risk with children who have shaky finances. These loans can also cause problems with other children who don’t get them. And, of course, many people are leery of real estate investments these days.

Still, an intra-family loan is worth considering for some. The most important guideline: the loan should not put a financial strain on either the parents or the kids.

Assuming the parents have plenty of resources, the ideal candidates are children who, in a normal market, could probably qualify for a regular mortgage. By getting an intra-family loan, they can saving on closing costs and perhaps, with accommodating parents, get by with less than the 20% down payment typical with regular mortgages today.

An intra-family loan could also serve those who are responsible but, under today’s super-tight lending standards, can’t get ordinary loans because they are self-employed, don’t yet have a long enough credit history, or show uneven income because they rely on commissions and bonuses.

Before setting up such an arrangement, parents and kids should agree on what will happen if things go wrong, as even the most responsible child can run into financial trouble from a lost job or other cause. In a normal market, troubled homeowners sell their properties. Since that can be very difficult today, the parties should have a clear understanding of whether the parents will forgive the debt or take ownership of the property by foreclosing.

The larger the loan relative to the property’s value, the more likely the parents will suffer a loss if things don’t work out. The parents should also study the local market to make sure the home is worth enough to cover the debt if the property must be sold.

To get the tax benefits of a normal mortgage, and to avoid running afoul of other tax regulations, the parents must charge interest at least as high as the applicable federal rate set by the IRS, currently around 2.6% for long-term loans.

While not legally required, it generally makes sense to have a lawyer draw up papers to assure the deal meets the income, estate and gift tax rules. The parties might also want terms to kick in if the kids want to pay the loan off early, or the parents later need a higher interest rate to match what they can earn in other ways–if and when banks and bonds are more generous, for instance.

Doing business with family can be tricky business. However, when it comes to the current generation of potentional homebuyers and the previous generation (many of whom cashed out of homes bought decades ago during the housing boom, leaving them with considerable income in retirement), keeping a mortgage in the family can make sense for all concerned.

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