Should you lend your child money to buy a home?
Your baby is all grown up and ready to buy a home.
Sally (or John) could go to a traditional lender to get a mortgage. Or she (or he) could turn to the Bank of Mom and Dad.
Should you lend your child money to buy a home?
Becoming your child’s lender can be financially beneficial, but it's also fraught with risk — perhaps more so than the typical investment because a family relationship is involved.
If Sally or John defaults, you have to foreclose on your own child.
Can you handle that?
On the other hand, you can earn close to 3% or more on a long-term loan, which is considerably more than what a savings account or certificate of deposit pays.
And your child will save on closing costs, private mortgage insurance and interest, because the cheapest traditional 30-year loans charge well more than the rate you could offer your child.
Most parents don't lend their children money to buy a home, but it's not unheard of.
According to the National Association of Realtors, 6% of first-time home buyers in 2012 received a loan from a friend or relative, typically their parents, to help purchase a house.
If you’re considering lending your child money, here are 5 facts you need to know.
Fact 1. Lending money to your kids can be a cause of conflict.
The single most important consideration is whether you can afford to have your money tied up in a loan for an extended period.
"Generally, families that are able to provide mortgages for their children have greater wealth," says Jeff Nauta, a certified financial planner and principal at Henrickson Nauta Wealth Advisors in Belmont, Mich.
If you think you'll rely on the mortgage payments to finance your own retirement, then late or missed payments can put you in a tough situation.
You know your child. Make sure she or he is already financially independent before considering a loan. You should not be the bank of last resort.
"The parent-child relationship may become strained when you loan the money and are not repaid correctly or the child is constantly paying late or buying things that the parent feels are improper or causing late payments," says Tim Gagnon, assistant academic specialist of accounting at Northeastern University’s D’Amore-McKim School of Business in Boston.
"But," Gagnon says, "can you foreclose on your child, can you evict your child and will they see you as the first payment they should make each month?"
Fact 2. You must follow the government’s rules to avoid the gift tax.
If you want to lend your child a large sum, you have to do it right to avoid incurring gift tax liability.
First, you must properly document the loan.
"The parents are going to have to work with a title and escrow company to create the required deed of trust documents and record these with the county in which the residence is located," says Kevin Gahagan, a certified financial planner and principal of Mosaic Financial Partners in San Francisco.
The child should also sign a promissory note that details how the loan is to be repaid, says Gregory B. Meyer, community relations manager with Meriwest Credit Union in San Jose, Calif.
You would want to formally record the transaction even if gift tax wasn't an issue.
This step protects your loan interest and your interest in the property, Meyer says. "Without it, should your kids fail to pay, your ability to get repaid through the trustee sale or foreclosure sale of the home could be compromised."
This formal loan document should state the loan’s interest rate, term and transferability, Gahagan says. It should also include an amortization table showing the balance remaining and equity accrued at any point in the loan’s lifespan.
Applicable Federal Rate
To determine what interest rate to charge, you’ll need to go to IRS.gov and look up the "applicable federal rate" for the month and year in which you finalize the loan.
For May 2013, the applicable federal rate for long-term loans is 2.57% if the interest is compounded monthly. That's about a percentage point less than the average 30-year mortgage interest rate.
There are significant (and complicated) tax consequences if you don’t charge at least this amount.
Gift tax issues also come into play if your child defaults on the mortgage.
If parents forgive the loan or don't pursue collection actions, the IRS may consider it a gift, Gagnon says, and if the loan is forgiven, the child may have to report it as income and pay tax on it.
For 2013, the annual gift tax exclusion is $14,000. This amount applies to each recipient, and each spouse can gift this amount tax-free.
The maximum amount parents could give a child without incurring gift tax liability would be $56,000 if each parent gave $14,000 to both their child and the child’s spouse.
Even the maximum amount is far less than most mortgages.
Fact 3. You also must follow rules to deduct mortgage interest.
Following the steps to avoid the gift tax will get you most of the way toward making sure your child can deduct mortgage interest payments.
Here are the additional steps:
- The parents must file IRS form 1098 to report the interest they received from the loan over the course of the year.
- They should provide a copy of this form to their child so the child knows how much interest to claim as a tax deduction on his or her tax return.
- The parents also must declare the interest reported on form 1098 as income on their tax returns.
Fact 4. There are companies that can help you formalize your loan agreement.
A third-party financial institution can simplify the loan process and increase the likelihood your child will pay you back.
One such intermediary is Boston-based National Family Mortgage, which has handled more than $81 million in loan volume while keeping more than $36 million of interest within families.
Some 85% of National Family Mortgage’s loans are between parents and their adult children. The average loan is for 23 years at a fixed rate of 3.27%.
The company says the default rate is less than 1% on the loans it manages.
National Family Mortgage also can help parents and children manage a mortgage with its loan servicing option, which will send a monthly statement and payment reminders, provide electronic payment processing and online account access, and establish an escrow account for property taxes and insurance.
Fact 5. This type of loan won’t show up on credit reports.
A loan between family members cannot build or damage the borrower's credit because it is not reported to credit agencies.
Parents can’t report the loan to the credit bureaus even if they want to because TransUnion, Experian and Equifax have rigid, cumbersome and expensive reporting requirements that few family lenders can meet, according to Tim Burke, the CEO of National Family Mortgage.
The agencies also have legitimate concerns that intrafamily loans could be abused to help a borrower build credit, Burke says.
If a child missed a mortgage payment, the parent might be tempted to grant amnesty by informing the credit agencies that no payment was due.