Becoming Your Child’s Lender Can Be Financially Beneficial
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?
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% on a long-term loan, which is considerably more than what a savings account or certificate of deposit pays. 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.
Most parents don’t lend their children money to buy a home, but it’s not unheard of. Somewhere around 6% of first-time home buyers receive a loan from a friend or relative. If you’re considering lending your child money, here are 5 facts you need to know.
Fact 1. Lending Money Can Cause 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, Michigan.
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.
You need to evaluate the loan much like a bank would, which means knowing your child’s credit and job history. Often, the potential for tension outweighs the financial considerations.
“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, associate academic specialist of accounting at Northeastern University’s D’Amore-McKim School of Business in Boston.
“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?” Gagnon asks. “Can you create a business relationship, without emotions, with your child?”
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 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. “This will secure their interest in the property.”
“A promissory note and mortgage should be executed between the parents and child,” he says. “Without this, the parents’ financial interest in the property could be jeopardized were the child to lose the house to creditors. It also provides evidence that the funds provided are a loan and not a gift.”
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 December 2019, for example, the applicable federal rate for a long-term loans is 1.59%. If the interest is compounded monthly, that’s more than 2 percentage points 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. Failure to do so could create a gift, or the IRS could deem the uncharged interest to be income and tax it.
Also, 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.
Gift tax issues are complicated — yet another reason why you should engage competent professionals to help you structure the loan and understand all of the details.
For 2019, the annual gift tax exclusion is $15,000. This amount applies to each recipient, and each spouse can give this amount tax-free.
The maximum amount parents could give a child without incurring gift-tax liability would be $30,000 if each parent gave $15,000 to both their child and the child’s spouse.
Even the maximum amount is far less than most mortgages.
Fact 3. You 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 should issue their child an IRS Form 1098 to report the interest the child paid on the loan over the course of the year. The 1098 tells the child how much interest to claim as a tax deduction on his or her tax return.
- The parents should declare the interest earned on the loan through IRS Form 1099 and report it as income on their tax returns. The 1098 and 1099 should match.
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 $400 million in loans while keeping more than $180 million of interest within families.
More than 4 of every 5 of National Family Mortgage’s loans are between parents and their adult children. Fees for this service run from $725 for loans of $100,000 or less to $2,100 for loans of $1 million or more. For an additional $15 a month, National Family will “service” the loan by sending monthly statements, collecting payments and providing year-end tax forms.
The company says the default rate is less than 1% on the loans it manages.
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 intrafamilial loans have an inherently biased creditor relationship and could be abused to help a borrower build credit. 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.