When Ada Owen* and her husband wanted to buy a foreclosure property this year in Tampa, Fla., they approached their bank for a typical mortgage loan.
But after being pre-approved, they were surprised to learn that the amount of interest they would pay over the lifetime of the loan would be enough to buy another home. Their surprise turned to dismay when they reviewed the loan paperwork—and discovered that the interest rate they were being charged was higher than the bank’s advertised rate.
Not wanting to give up the opportunity to buy a house, Owen and her husband decided to look closer to home for the money that they needed. The source? Her mother.
“We borrowed $100,000 from my mom over a nine-year term,” Owen says. Borrowing within the family allowed them to negotiate an interest rate below market rates, and set loan terms that best suited their needs. “By the time we pay off our mortgage, we will be in our early 40s--and debt free!” she says.
The arrangement also offered Owen peace of mind that she may not have had if she’d opted for a more traditional bank mortgage. “Dealing with a family member is a more comfortable and secure way to go," she says. "For my family, the loan is securer than a stock investment, and the income is predictable—a constant flow. It is a win-win for both sides.”
Who Uses Family Loans?
Owen is hardly alone in turning to the Bank of Mom and Dad. With credit still tight in the aftermath of the financial crisis, many borrowers are asking family members to loan them money to pay off student loans, start a business, buy a house or pay for a wedding. Last year, 6% of first-time homebuyers who financed the purchase received a loan from a relative or friend, according to the National Association of Realtors.
“Intra-family loans are an excellent strategy that can benefit both the lender and the borrower," says Benjamin Sullivan, a Certified Financial Planner™ based in Scarsdale, N.Y. “The borrower can get easy access to a loan that they might not otherwise qualify for, and usually at a much lower rate than one offered by commercial lenders.” Parents who have enough money to lend also may get a safe investment with a higher rate of return than they would with savings accounts or bonds, he adds.
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Some parents look at loans given to their adult children as an investment toward the future. Diana Kuyper of Salem, Wis., loaned money to her daughter and son-in-law after the couple ran into obstacles trying to refinance their home through a bank. In return for the loan, Kuyper receives 3% interest, which is more than she would make with a conventional CD or money market account. And her daughter got a low-interest mortgage without having to pay for private mortgage insurance. “I think of it as an annuity,” Kuyper says. “They are saving hundreds of dollars every month.”
What Lenders Need to Know About Giving Money to Family
Family members who are considering lending should first think about whether they truly can afford it. Unforeseen problems, like a job loss or a medical emergency, might leave you needing the cash you loaned. "You want to avoid feeling like you’ve loaned out more than you should have,” Sullivan says. “Since you can’t force the borrower to repay early, you have to plan for the unexpected.”
For that reason, a loan shouldn't come from savings that you might need in the future. “We don’t advocate loaning money that's earmarked for emergency or retirement funds,” says David Blaylock, a Certified Financial Planner™ with LearnVest Planning Services. “It should be money that's above and beyond what the lender needs to meet his or her goals.”
And a loan should always be a well-thought-out choice—not a reaction to a crisis. “Intra-family loans work best as a deliberate investment strategy,” says Timothy Burke, C.E.O. of National Family Mortgage, an organization that has helped family members lend more than $120 million to one another to pay for mortgages since 2010. "They tend to go poorly in response to a borrower with an emergency.”
Of course, if a lender does not need the money to be repaid, another option is to transfer the money as a gift. For 2013, a person can give up to $14,000 per recipient annually without paying gift taxes. This means that a mother and father could separately give a son and his wife $14,000 each, for a total of $56,000 to the couple in a single year, without running afoul of tax rules. But a cent above $14,000 per person requires filing a gift tax return, and counts toward the $5.25 million limit people are allowed to give tax-free during their lifetimes.
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Intra-Family Loans: How to Set Them Up Properly
If you are considering an intra-family loan, it can pay to do it right. “Properly structuring and documenting the arrangement sets clear expectations, protects relationships and prevents legal and tax problems in the future,” Burke says.
It’s important to document the loan with a written agreement, and to set a fixed repayment schedule, Burke explains. This not only helps the loan stand up to Internal Revenue Service scrutiny, but it also prevents future misunderstandings or ill will among family members. It isn't recommended that you "document" your own transaction—you must file it with the appropriate authorities or face possible I.R.S. fallout. National Family Mortgage charges a one-time flat fee of $725 to document and register a mortgage loan with the proper state-specific governmental authorities, which means borrowers can legally deduct their interest payments from their federal tax returns, just like with a bank mortgage.
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For the transfer to be considered a loan (and not a taxable gift) in the eyes of the I.R.S., a minimum level of interest must be charged, based on a number known as the Applicable Federal Rate, which is set by the I.R.S. each month and listed on its website. In October 2013, the minimum monthly interest rate for a short-term loan under three years is 0.32%; for a mid-term loan between three and nine years, it's 1.91%; and for long-term loans over nine years, it's 3.45%.
When done right, an intra-family loan is not only a smart financial move, says Blaylock, but it can make everyone feel good. “The reality is that we want to help family members, and we enjoy seeing them succeed financially," he says. "And if this is something that enables them do that—like put a down payment on a home—it's something that can help a family grow their wealth.”
*Some names have been changed.
LearnVest Planning Services is a registered investment adviser and subsidiary of LearnVest, Inc. that provides financial plans for its clients. Information shown is for illustrative purposes only and is not intended as investment advice. Please consult a financial adviser for advice specific to your financial situation. The people quoted in this piece are not clients of LearnVest Planning Services. LearnVest Planning Services and any third parties listed in this message are separate and unaffiliated and are not responsible for each other’s products, services or policies.