Could an Intrafamily Home Loan Help Save Thousands on Interest?
A home is likely the most expensive thing you will ever buy. Most homebuyers finance this purchase with a traditional mortgage, which can be expensive depending on your credit score and current interest rates. A more affordable family loan can be a good alternative to the traditional mortgage and help the borrower save money in interest payments — but if the agreement goes awry there can be broader consequences.
An intrafamily home loan can be a great way to leverage money across generations. The borrower gets a lower interest rate and doesn’t have to pay as much in origination costs, while the lender can earn a higher rate of return than they would by investing in a bond portfolio. And with a lower-interest-rate mortgage, the borrower may be able to afford a house that would otherwise be too expensive.
But money is a subject that’s rarely discussed within families — and understandably so. “Money manners are always very emotional,” says chartered financial analyst Robert Stammers, director of investor education for the CFA Institute. “Relationships break down when one person thinks the other isn’t doing what they originally promised to do or when one party sees it as a loan and the other sees it as a gift.”
Since relationships can be damaged when loans aren’t repaid, both the lender and borrower need to take care during this process to do their homework. Do you best to keep everyone happy and on speaking terms with these three tips.
Before lending money, the potential lender should consider their own finances first. They need to look at their budget and whether lending this money will strain their own financial plan. A traditional lender will review a potential borrower’s finances, and so should the family member acting as the lender.
As with any loan, there is a risk of not being repaid, so the lender should also consider if they could afford to gift this money in the event of a worst-case scenario. Even though the loan is backed by collateral in the form of a house, foreclosing on a property where a relative lives is a very difficult decision, especially considering the potential for causing a rift in the relationship.
Discuss the terms
Agreeing on loan terms is important for a few reasons. A willingness to pay interest by the borrower is a sign of their seriousness to repay the loan — but there are also financial considerations.
The IRS treats loans and gifts to family members differently. One key way to differentiate these is by charging interest, and the IRS publishes interest rates for family loans in the Applicable Federal Rates (AFR) tables. These are the base rates before the loan is considered an actual gift.
The AFR tables are published monthly and vary depending on loan terms. As of August, long-term loans extending beyond nine years are at 2.78%. For comparison, the interest rate for a 30-year fixed-rate mortgage for the same period is about 4.13%, while that for a 15-year fixed is 3.28%, according to Bankrate.com. Over a loan’s lifetime, depending on the mortgage balance, the difference in rates could save the borrower thousands of dollars.
The IRS considers any waived interest payments to be a gift, and this money is taxed as ordinary income whether or not the lender receives it. There is a $ 14,000 annual gift tax exclusion limit, as well as a $ 5.43 million basic exclusion — the amount an individual can leave to heirs without being required to pay a federal estate tax — but the lender has to file a gift tax form to avoid the tax.
Since the AFR is updated monthly, the borrower and lender should agree on how often, if at all, the interest rate is adjusted. Other provisions up for discussion are the repayment term and whether there will be any penalties for paying off the loan early.
Formalize the loan
Treating the loan as a business arrangement is the best way to protect a relationship, but there are also financial benefits for both parties in a formal agreement. The borrower can deduct mortgage interest only if the loan is formalized, and for the terms to be enforceable, a lender should make sure the agreement documents are dated, signed, witnessed, and notarized.
Having a lawyer help draft and review these legal agreements is a good idea so that you can be sure everything has been done correctly.
“Writing it all down sets the boundaries so that people can’t do something differently than what they promised to do when they made the original loan,” says Stammers. “Formal arrangements remove any ambiguity — being specific protects the lender and borrower because it sets expectations for both parties.”
A few basic documents should be included in the loan paperwork. A promissory note is signed by the borrower and explains the agreed-upon terms, such as loan balance, term, interest rate, and payment frequency, as well as what happens if the borrower is delinquent, for example. This document also includes the borrower’s promise to repay the loan.
The mortgage or “deed of trust” secures the collateral for the loan, which is the house in this case. Along with detail on the borrower’s responsibilities, such as maintaining hazard insurance, paying the mortgage principal and interest payments and taxes on time, and maintaining the property, this document also includes detail for what happens if the borrower doesn’t make payments. This additionally states that the lender can foreclose on the home or ask for immediate and full payment of the loan if the borrower doesn’t comply with the terms. The lender can’t collect on the mortgage through a home sale without this document.
A repayment schedule isn’t required, as it’s more of a good-faith document that spells out when and what payments the borrower will make over the life of the loan.
Have you ever entered into an intrafamily loan agreement? Share your experience and tips in the comments below!