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Plan a Visit to the “Family Bank”

Family bank

In the ongoing difficult borrowing environment, some potential homebuyers have found the best way to finance a purchase is not from a major commercial bank, but from the “family bank” instead.

As long as IRS guidelines are followed, the transaction can be remarkably appealing, with more flexible lending terms, IRS-required Applicable Federal Rates that are still lower than commercial mortgage rates, the potential to still deduct mortgage interest payments for the borrower, avoidance of origination and many other mortgage transaction fees, and the simple benefit that all the interest and principal payments ultimately stay in the family.

A major downside, however, is that to ensure the IRS truly respects the transaction – and to receive some of the tax benefits as well – formalities of the loan should be honored, including drafting a promissory note, recording the mortgage against the residence in the proper jurisdiction, and completing actual payments of interest and/or principal.

The basic principle of an intra-family loan is fairly straightforward – rather than borrowing money from a bank, a family member in need borrows money from someone else in the family, such as a child borrowing money from his/her parents. The benefits of doing so are significant: the interest costs paid by the child stay in the family (to be used by the parents or in the extreme, inherited back by the child in the future!); origination and other transaction fees may be avoided; the borrowing cost for the child is typically much lower than interest rates from the bank; yet (especially in today’s environment) the interest rate paid is still better than what the parents may have been able to earn from a bond portfolio.

For instance, in today’s marketplace, the parents could loan money to the child for a 30-year mortgage at 2.5%, which is much less expensive than a 30-year fixed rate mortgage at 3.5% (or higher, depending on loan-to-value, the size of the loan, and the borrower’s credit score). Yet the parents still generate interest at 2.5%; while meager, that’s better than what they’ll likely get from CDs (although notably, lending money out as a mortgage is a far less liquid for the lender!). In addition, if the loan is a mortgage that is actually secured to the residence the child purchases and is properly recorded, the child can still deduct the mortgage interest paid to the parents! (Of course, the parents will have to report the interest received on their tax return, just like any other “bond” interest.) And the loan can be structured as interest-only to reduce the cash flow obligations to the child (although obviously not amortizing the loan principal decreases the cash flow payments to the parents as well).

An added benefit of intra-family loans, especially as a mortgage for purchasing a residence, is that some of the constraints of traditional loan underwriting are no longer an issue; for instance, family members don’t have to charge more for a child with a bad credit score, and can freely provide loans up to 100% of the purchase price without requiring a down payment. The loan could be for a primary purchase, or a refinance, or a renovation, and can even be structured as a 2nd or 3rd lien against the house. One popular strategy is for children to borrow up to 80% using a traditional mortgage for a new home purchase, but borrow money from parents to fund the downpayment for the remaining 20% (recorded as a second lien on the residence).

Of course, the caveat is that engaging in such strategies does create a genuine risk for the lender that the loan interest and/or principal will not be fully repaid (there’s a reason why banks require higher rates to compensate for greater credit risks and smaller down payments!), so the family-member-as-lender should be cautious not to lend funds in a manner where a partial default by the family borrower could actually create financial distress for the family! Similarly, the family-member-as-lender needs to be cautious not to get stuck in too illiquid of a position, although it’s always possible to put a demand provision into the family loan (which, of course, still runs the risk that the family-borrower won’t be able to refinance or pay back the note in whole in a timely manner!).

Anytime you make a loan you need to consider how it impacts your estate plan as this is actually an asset that would be subject to probate unless you make the lender your revocable living trust.  We can help you with this planning; just call us at 757.259.0707 or click this handy link to request your complimentary consultation. 

 

 

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We've been putting together as many resources as possible so that we can continue to help:

  • If you’re a current client with a signing appointment or a prospective client with a consultation and would prefer that meeting take place in your own home, we can accomplish that with a little bit of pre-planning on our part and with the addition of a laptop, smartphone, tablet or other computer in your home to facilitate this virtual meeting. For those of you that need to sign legal documents, that too can be accomplished with the use of a webcam (FaceTime etc.), so that we can witness and electronically notarize all of your important legal documents.
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Thank you, Walt and the Zaremba Team

Coronavirus/Covid-19
Update to our Process

The unprecedented coronavirus pandemic has taken our entire country by surprise. We understand how difficult this time is for America’s businesses and families.  However, we believe it is vitally important that we make every effort possible to continue to offer solutions that avoid disrupting our important partnership with you, your family and friends.  As you know, estate planning is not something that should wait for a more convenient time, therefore the opportunity to address your important goals both during and after this crisis should not wait.  To that end, we have added the option of a ‘virtual consultation’ to our office process.  You will now have a choice of either meeting with us in our office or in the comfort of your own home.