Family (Money) Matters: The Right Way to Give Loans to Relatives
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.”