Family Loans Make Sense for Home Buyers

Bob Hope once said, “A bank is a place that will lend you money if you can prove that you don’t need it.” Maybe that explains why more and more home buyers are turning to their loved ones, and even more distant members of their circle, for help with financing. If done right, tapping the “Bank of Family and Friends” can be financially lucrative for both you and the person lending you the money. You get the cash you need, they earn interest at a rate equal to or even higher than they could have gotten elsewhere–everyone wins.

Commonly called a private home loan, a private mortgage or an intrafamily mortgage–even though your private lender can be someone other than a family member–these types of loans are legally speaking no different than a mortgage originated by a bank, credit union, or other institutional lender. As with an institutional loan, you’ll normally sign a written contract and establish a schedule of monthly repayments with interest. Your private lender will hold a lien on your property and have the legal right to demand full payment on the outstanding balance if you fall behind in making payments. Your private lender can even foreclose if you default on the loan (though few would go so far).

Rest assured, you have legal rights as well. Your parents can’t foreclose on your house just because you arrive late for their 50th wedding anniversary, and your best friend can’t demand an early payoff just because he or she wants to buy a new car.

How a Private Home Loan Helps the Borrower

By turning to the bank of mom and dad, your favorite aunt or uncle, your in-laws, a brother or sister, or even your best friend or business colleague for home financing help, you might gain the following:

–A lower interest rate. Borrowing from a relative or friend can mean a lower-interest loan than you’d be able to qualify for elsewhere. That’s because you and your family-or-friend lender are the ones who determine the interest rate. Most private lenders are, based on their personal relationship with the borrower, willing to accept less interest than any bank would.

–Flexibility in paying back the money. Unlike banks and other institutional lenders, how and when you pay back your family or friend is up to you and them. That flexibility can allow you to arrange a loan with an unusual repayment schedule at the outset, or to later temporarily pause payments due to unforeseen circumstances, extend the length of the loan, and more. But be careful: If abused, this very flexibility can cause strained relationships.

–Federal tax deductions. Just as with a loan from a bank, private loans allow you to benefit from the federal tax deduction for home loan interest paid. This can add up to tens of thousands of dollars in savings over the life of the loan. For example, suppose you have a $150,000 private home loan from your uncle at 6% interest over 30 years, and you are in the 25% tax bracket. Over the life of that loan, you will save about $45,000 through tax deductions. That’s a nice chunk of change.

How Making a Private Home Loan Helps Your Relative or Friend, the Lender

Whether your private lender is a relative or a friend, he or she stands to gain in a number of ways, such as:

–Achieving a better return than might be gotten through other investments. The kind of money you’re looking for won’t simply be sitting in your lender’s checking account. In fact, before loaning you the money, your lender will most likely have to withdraw it from another investment vehicle, such as a money-market account or certificate of deposit (CD). But the switch may be worth it, since you can, even without paying as much interest as you’d pay to a bank, probably offer higher interest than the person could get on their current investments.

–Generating a steady income stream. Private mortgages are ordinarily repaid over time as opposed to in one lump sum (unless, of course, you sell your house, at which point you’d have to pay off the private mortgage in full). By setting up and following a repayment schedule, for example, with payments due on the 1st of every month, your payments can actually become a steady income stream for your family or friend lender.

Your Family and Friends Don’t Need to Be Rich

So now you’re probably thinking, “If only my parents were the Hiltons instead of Mr. and Mrs. Everyday USA” or “Why couldn’t my college roommate have been Bill Gates instead of Joe Ordinary?” You’re not alone in thinking this way. It’s the number one misconception surrounding intrafamily mortgages, and the reason that many people miss out on this home-financing opportunity. The truth is that your family and friends don’t need to be rich to offer a private mortgage. They simply need to have some cash that they can part with for a short time, and the confidence that you will pay the money back without them having to foreclose on your home.

Preparing the Loan Paperwork

Once your private lender has agreed to loan you money to finance all or a portion of your home, you’ll want to handle the transaction almost as a bank would. This includes drafting and signing a written promissory note and supporting mortgage documents. It’s a good idea, although not required, to draft a written repayment schedule as well.

–Promissory note. Also referred to as a mortgage note, this is a legally binding document signed by you, the borrower, saying that you promise to repay the loan under agreed-upon terms. These terms should be spelled out in the note, and cover the interest rate, payment dates, and frequency of payment. The note should also describe any penalties that the lender can assess if you fall behind in repaying the loan, including requiring full payment prior to the end of the loan term.

–Mortgage or “deed of trust” (depending on which state the property is located in). This is a legal document that secures (provides collateral for) the promissory note. It says if you don’t pay back the loan, plus all fees and interest, then your private lender can foreclose on your property and use the proceeds to pay off the loan. Depending on your state, you will have either a “mortgage” or a “deed of trust.” The difference is that a mortgage involves two parties (you as the borrower and your family member or friend as the lender), while a deed of trust involves three (you, your family member or friend, and a trustee-usually an attorney or title company-to act as a neutral third party holding temporary title to the property until you pay off the loan). The mortgage or deed of trust lists the currently recognized owner and legal property description, and describes the borrower’s responsibility to: a) pay principal, interest, taxes, and insurance in a timely manner; b) maintain hazard insurance on the property; and c) adequately maintain the property. If you fail to comply with these requirements, your private lender can demand immediate, full payment of the loan balance.

–Repayment schedule. You’d never think of telling a lending bank, “I’ll pay you back when I have the cash.” Yet a surprising number of borrowers try this on their friends and family members–or assume it’s okay without even asking! In fact, the main source of friction between private borrowers and lenders usually occurs over miscommunications about when payments should be made. Although a written repayment schedule is not legally required, it’s both a convenient and an important way to avoid straining the relationship with your family-or-friend lender.

After You Receive the Loan

After the loan is made (that is, the documents are completed and the money is in your hands), your obligations should be pretty clear: Send the lender regular repayments, at the time and in the manner set out in your promissory note. Also comply with any other requirements set out in the note, such as maintaining your homeowner’s insurance.

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