Is a Private Family Loan a Good Idea?

A common private mortgage lending option that arises is pursuing a private family loan to purchase or refinance a home or property. Although private family loans can seem like a good idea, taking the time to research what it takes to setup the loan properly can be non-trivial depending on the location and financial situations of both the lender and borrower. In order to keep family loans from going bad, there are a number of personal, financial, and family relationship pitfalls to discuss and consider before finalizing a private family home loan.

What is a Family Loan?

Family loans are any loan transaction between two or more family members. Although a family loan can be done for any reason, they are also used for private mortgage loans. Before taking the first step in setting up a family loan, the financial considerations of the transaction should be analyzed by both the prospective borrower and lender. The transaction should make financial sense for both parties. The significant factors to consider include: 1 – The private family loan is a better financial deal for the borrower than he or she may realize from a publicly backed mortgage, 2 – The loan is a good deal for the lender, and 3 – The family loan is compliant with all local real estate and tax laws.

Accounting for Tax Laws

There are a number of tax law pitfalls that can befall family home loans. If the family lender forgives loan balances, payments, or charges too little interest on the loan there can be issues that arise when attempting to claim federal and / or state tax deductions on the home loan interest. Although it does not seem intuitive, if the family lender does not charge at least the Applicable Federal Rate (AFR) on the family home loan, the borrower, or mortgagor may not be legally allowed to take any tax credit on the note. Similarly, there is no break allowed on paying local property taxes (if required) for the locality the property or home is located.

Mixing Emotions with Business

This is perhaps one of the most significant factors with a family home loan. When a mortgagor seeks out a home loan through a private or publicly backed lender, the act is simply a business transaction. In a family home loan, personally knowing the other person makes working through the deal more complicated. If the agreement does not proceed smoothly, family relationships can become negative and impact day-to-day life. The most successful family home loans are based on openness regarding the objectives of both the borrower and the lender. This will help ensure both the borrower and lender are looking at the prospective loan in the same manner. Similarly, one school of thought for family loans is that lenders should be ready to lose money on the mortgage up-front. If he or she is not, then the family loan route is not likely a good idea unless there is equivalent capital available to secure the loan.

Family Loan Documentation

All family home loans should be formally documented and not based on word-of-mouth. This includes annotating the terms of the loan similar to a mortgage company or bank. If the borrower intends on using collateral to secure the loan, the documentation must be sufficient to secure the interest of the lender. For most consumers, retaining the assistance of an attorney is a must for creating and validating the loan documentation properly.

Taking the time to create solid documentation for the loan helps keep both family members in synchronization on the loan. Sample loan documents and purchase loan agreements can be found online; however, it is still recommended to pay a service provider or expert to review and formalize the family loan documentation. Additionally, there are a number of P2P lending sites available online which can help provide the correct documentation templates, legal advice, and other information that can save you time and/or money prior to retaining professional advice on the loan.

How Does Collateral Work?

Even for family loans, it can be a good idea to have the borrower put up collateral for the loan. Collateral can be provided in the form of other property, vehicles, boats, stocks, bonds, or retirement accounts. By including collateral in the loan, the member who is lending the money to the borrower takes on less risk than if requiring this.

Officially, collateral is defined as being something of value (whether property or other assets) that is pledged when obtaining a loan. If the loan is not paid as agreed upon with the terms, the lender may then seize the collateral and sell it. There are a number of assets that can be used as collateral on a loan. These include physical things such as a truck, car, boat, or home as well as other “intangible” assets such as stocks, bonds, and bank accounts depending on the nature of the loan terms.

In some states, collateral is considered to be the actual home you are purchasing. For example, the guarantee of the loan to the family member providing you the loan is that they will be able to sell the home if the borrower defaults on the mortgage or otherwise fails to live up to the terms of the loan. Conceptually, this can be thought of as being similar to what happens on auto loans when the borrower fails to pay their debt according to the agreed upon terms.

Why is Collateral Used for Loans?

Many times consumers will inquire on the need for providing collateral on a loan. Typically, a lender will consider a loan to be of lower risk if the borrower stands to lose something of significant value when compared to the amount of money being financed. For home loans, banks and smart family members will insist on the right to repossess the home to resell if the mortgage goes into default as a means to recoup the financial investment in the property. Sometimes, borrowers may have to provide additional collateral on loans in the event the lender can’t be assured of having full control over the resell of a property.

Obtaining a Loan without Collateral

This is less common when seeking out a family loan for a mortgage than in the credit industry. If a family member provides another a home loan without doing the proper paperwork to be able to repossess the home in the event of default, then he or she will also stand to lose a significant amount of money. This type of loan is commonly referred to as a signature or unsecured loan. Depending on the contractual terms, the lender may not even be able to have a negative impact on the credit score of the borrower if the loan goes into default.

More formally, an unsecure loan is one that is not connected to any physical or monetary collateral. There is no asset for the lender to pursue if the borrower goes into default.

What are the Disadvantages of Family Loans?

#1 – Either family member being unclear about the overall objectives of the loan.

This is one of the most common mistakes made when pursuing a private family loan for a mortgage. Most private family loans that are successful have clear communication throughout the loan process on expectations. For the family member making the loan, some considerations include: Why is the person actually providing the loan? Is there an expectation of making a profit, or is the family member just making the loan to help out a relative in need? Is there an expectation to be repaid via regular payments? What’s the expectation if the family member starts to default on the agreed upon terms?

For those looking to borrow money from a family member to buy or refinance a home some good questions to ask include: Why do you want to borrow money from a family member? Do you expect to regular make payments on the loan? Are you able to actually pay the loan back at regular intervals? What will you do if you can’t make payments?

#2 – Failing to properly document the family home loan.

Most successful family home loans work the best when they go through the formal documentation process similar to seeking out a loan from a bank or other lending institution. This includes an agreement which lays out the details on when the loan payments are made, required collateral, and what happens if the loan goes into default. With a formally documented loan, no one will forget how the loan is supposed to be setup with a legal agreement in place. This makes for less impact from emotions or other disagreements between the parties. If the borrower intends to deduct interest on taxes, the agreement will also be required and should be analyzed by a tax advisor or attorney prior to closing on the loan.

#3 – Failing to properly secure the family home loan.

Whenever possible, it’s always preferred to secure family home loans. This ensures that the lender has some type of risk mitigation in the event the borrower fails to pay the loan back, is hospitalized, or passes away. This helps reduce the risk to the lender and gives an added incentive to the family member to pay the loan back.

#4 – Failing to follow local and federal tax laws.

A family home loan can impact the tax liability of both the borrower and the lender. Lenders will have to report any income earned on the interest, and they can inadvertently make a taxable gift to the family member obtaining the loan if it fails to meet IRS or local tax criteria. Similarly, if a borrower desires to deduct the interest paid on a family home loan, they can only do so if it is setup properly according to federal and state law. Working with an attorney and tax advisor early in the family home loan process can help benefit all parties to the loan and avoid legal risks.

#5 – Failing to follow other property or mortgage laws.

Tax laws are not the only ones that borrowers and lenders must be aware of when dealing with family home loans. Common areas that must be setup in accordance with the applicable regulations include:

Conditions for when a home can be foreclosed upon or other collateral collected, the estate settlement procedures in the event of the borrower’s death, and how debt will be collected and reported to the applicable credit reporting agencies. Coordinating the deal through an attorney will help avoid many of these pitfalls. Although the fees will cost money, this small amount can save a lot of money in the future if things go awry.

#6 – Placing the family member lending the money at risk.

A family home loan should benefit both parties at some level. Although a lender always takes on some level of risk, this should be minimized as much as possible when doing business within a family. One of the common mistakes is the family member making the loan not having sufficient assets to actually lend the money. In the effort to “do good” or help younger family members, some will be tempted to place their financial futures at risk in order to provide the financial backing for the loan. Some aspects of providing money to another family member as the “lender” to watch out for include: taking money out of retirement accounts or borrowing against them to make the loan, tapping in to their emergency savings funds to make the loan occur, or taking out a home equity loan. In all cases, lenders should only make family home loans using excess money that can be afforded to be lost in the worst-case while trying to minimize their overall risk.

#7 Failing to seek-out alternative loan options for the mortgage.

A family home loan may be the wrong choice to make for a new home mortgage. The potential borrower should make sure that they can’t find an equivalent deal through a public or private lending institution before taking on the added risk of borrowing a significant amount of money from a family member. If a bank will not lend to you, another option that potential home buyers can investigate is using a peer-to-peer lending service. These options may prove to be better than a family home loan and don’t run the risk of potentially ruining Christmas Dinner!