In response to growing inflation and other economic pressures, the Federal Reserve recently raised its key benchmark interest rate by 75-basis points, the largest single increase since 1994. This has predictably increased mortgage rates from 3.0% in October 2021 to upwards of 6.5% today (a 3.5% increase in approximately 8 months!).
Many homebuyers, especially first-time homebuyers, are feeling the financial impact of the Fed’s rate increase. Back in October 2021 a $350,000 loan (representing the approximate median home in Minnesota), at 3.0% would result in a $1,476 monthly payment with $181,221 in total interest paid over the lifetime of the loan. In June 2022, that same loan has a $2,212 monthly payment and $446,406 total interest paid. That is a $736 increase of monthly payment and an extra $265,185 interest paid. Homebuyers have other options.
In response to the increasing mortgage rates many potential homebuyers are investigating whether their parents could help finance the purchase. If the parents have sufficient financial resources, they can take the place of a traditional lender by loaning funds to their child and take a mortgage against the property. Of course, this arrangement comes with its own unique benefits and risks.
The obvious benefit is parents can loan money at a significantly lower interest rate than a traditional lender. The child should not expect a 30-year loan at 0%. If this money was not loaned to the child, it would have been earning a return for the parents. Thus, it is only fair for the parents to earn some interest. The approximate going Federal Funds Rate is a good place to start. If the loan is documented correctly, the interest paid by the child is reported as taxable interest income to the parents and deductible mortgage interest to the child.
The parties can also get creative with the payment schedule. The loan can be structured for amortized payments, interest only payments, or even fixed amount. Payment can be monthly, quarterly, or annually. A parent-lender arrangement offers greater speed and flexibility to the parties. The parents may not require the child to provide W-2s or bank statements. A child with a less-than-stellar credit history who may be unacceptable to a traditional lender could be acceptable to the parent. Relatedly, the child can also avoid paying mortgage insurance. Unlike a traditional lender, the parents typically will not maintain an escrow account for property taxes and insurance. These expenses will be the child’s/borrower’s responsibility.
The most obvious risk in this arrangement is what happens if the child defaults on the loan. Are the parents willing to declare their child in default and potentially start a foreclosure against their child? The parents likely do not want to end up owning the home as a result of a foreclosure. This puts the parents in a difficult position. If the parents have other children, will this arrangement be perceived as fair to the other children? Do the parents have the financial means to make similar loans to their other children so avoid the perception of favoritism? What happens if the parents die while the loan is outstanding?
Before parents agree to loan money to their child all legal and financial risks and benefits should be discussed and evaluated with qualified professionals to mitigate the risk of unintended consequences. For example, if not properly incorporated into the parents’ Estate Plan this loan could result having to Probate in the event of a parent’s death before the loan is paid back. Assigning the loan debt to a Revocable Trust created by the parents is a simple, cost efficient, and effective option.
For questions regarding Estate Planning or parent lending, please feel free to contact the author, Karl Tsuchiya, [email protected] or 952-460-9271.