Given today’s high home prices, many parents these days want to help their adult children buy their first home.
One way to do that is through an intra-family loan that works for parents and children.
You may be able to offer your child a lower interest rate than a conventional mortgage lender would while still earning a higher interest rate than you could earn from a savings account. For example, if you provide your child with a mortgage at a 4.5 percent interest rate, you’ll earn more than four percentage points more than the 0.24 percent average yield for a bank savings account. Your child, meanwhile, will pay significantly less than the national average for a 30-year fixed-rate mortgage, which was 6.86 percent in early April, according to Bankrate.com.
An intra-family loan works particularly for well-off parents who can afford to give their children the money but prefer the financial discipline that comes with a loan, says Tim Burke, chief executive officer of National Family Mortgage, a family lending agency. “For many parents, the motivation to lend money over gifting it is just about personal accountability,” he says.
If parents need assurance that their child can afford the monthly payments, they should ask the child to get preapproved for a conventional mortgage, Burke says. If your child can’t get preapproval, it comes down to your judgment.
Put the terms of the intra-family loan in writing so they’re clear and it’s an arm’s-length transaction, says Brian Lamborne, senior director of advanced planning at Northwestern Mutual. This can also help you deal with instances in which your children are unable to make payments. For example, you can agree ahead of time that should your child suffer a financial hardship, payments will be deferred for a certain period—perhaps six months or up to a year—and moved to the end of the loan.
The loan agreement should contemplate worst-case scenarios as well. For example, you may want to state the conditions under which the parents could foreclose on the property so they can sell it and pay off the loan.
It’s also important to understand the tax implications for family loans. Borrowers who itemize can only deduct interest on a loan secured by a mortgage if the mortgage has been properly recorded. To do that, families need to obtain a deed of trust and file it with the borrower’s local government authority, such as the registrar of deeds or country clerk’s office. A real estate attorney can help you draw up these documents.
If the loan exceeds $10,000, the Internal Revenue Service (IRS) requires you to charge an interest rate equal to or above the Applicable Federal Rate (AFR), which the IRS publishes monthly. The AFR for long-term loans is 3.79 percent as of February 2023. The interest must be reported as income on your tax return.
If you don’t want to act as the loan servicer, you could use National Family Mortgage to set up, document and service the loan. It will email payment reminders and monthly statements, collect and credit payments, and issue year-end IRS 1098 and 1099-INT tax forms. Cost: a one-time fee of $725 to $2,100, depending on the size of the loan, and optional loan servicing starting at $15 per month.
