It’s not a good time to buy a home in most of the United States.
Home prices are much higher than they were five years ago. Mortgage interest rates are much higher as well. As a result, money expert Clark Howard expects home values to correct, or at least to grow at a much slower rate, for the next several years.
Just a few years ago, finding interest rates below 3% was common for those with good credit scores. The current average 30-year fixed mortgage rate is 7.00% according to Bankrate.
Also, consider the run-up in home values. Now layer a much higher interest rate on top. It creates mortgage payments that for many are just not affordable.
It has caused people to look for ways around those high mortgage rates. One creative alternative is to get a home loan from a family member. They’re allowed to legally offer you a mortgage at a much lower rate.
How Does a Mortgage Loan From a Family Member Work?
Can I really get a mortgage loan from a family member? And how does that work?
That’s what a listener recently asked Clark.
Asked Steve in Indiana: “My parents offered to loan money to us for a home purchase so we could avoid dealing with the currently high mortgage rates.
“What sort of things do I need to consider before setting up this arrangement? Are there restrictions from the IRS? Would this negatively impact our ability to buy a home in any way?”
A family member can give you a loan for part or all of your mortgage. The IRS offers guidance and requirements on these favorable family loans.
Let’s address Steve’s last question first. The family loan will become what the industry calls a mezzanine loan. That makes it easier for the seller and it will help you get a deal done and close on the house, Clark says.
“They are giving you a gift. Because they’re making a loan for a home that eliminates a wide variety of closing costs. And they’re willing to make you a loan at what would be well below market rates. But legal within the IRS requirements,” Clark says.
Private Family Loan: Explaining Applicable Federal Rates (AFRs)
These family loans fall under the guidelines of Applicable Federal Rates (AFRs). The IRS publishes the minimum rate that private lenders can charge borrowers in order to avoid tax complications.
You can find the updated AFR rates on the IRS website each month. They’re organized by short-term (repayment term up to three years), mid-term (between three and nine years) and long-term (greater than nine years).
Once you and your family member agree on the length of the loan term, you’ll use the AFR rate chart for the month that you originate the loan.
“You have to be charged what the IRS establishes as an acceptable rate of interest,” Clark says. “Or otherwise, it’s treated as if your parents gave you a gift.”
In other words, if Steve’s parents don’t charge the minimum interest rate that the IRS stipulates, and the money exceeds the allowable annual gift amount, they’ll create major tax consequences.
What Risks Do the Family Lender and Borrower Face?
The borrower, Steve in this case, is not assuming any of the risk.
“The risk is really to your parents that if at some point something happened in your life and you didn’t pay. Your parents are then in a terrible situation where they have to choose if they’re gonna foreclose or what are they gonna do about the money you’re not paying,” Clark says.
“So the risk is always to the lender in that case. Not you as the borrower.
“One other thing: You have to have this done like a traditional real estate closing with a lawyer who does the proper paperwork where the loan is secured by the real estate – i.e. a mortgage. As long as you do that? You’re good to go.”
Of course, there’s a risk of tax consequences if the borrower does not uphold the minimum interest rate the IRS establishes through its AFRs.
Final Thoughts
You can get a private mortgage loan from a family member. However, you need to make it official and follow the IRS guidelines. That includes a minimum amount of required interest.
Also, the lender assumes the risk. If the borrower isn’t paying back the money per the loan terms, the lender must decide to foreclose on their family member — or eat the loss.
