In 1991, Dan Driscoll of Towson, Md., and his wife, Theresa, wanted to buy a house, but the lowest mortgage rate they could find was 9%. Meanwhile, Driscoll's parents, who were retired, were earning 3% on their savings. At Driscoll's suggestion, his parents financed his $75,000 mortgage at a 6% rate.
Now, Driscoll has taken on a different role. Earlier this year, Driscoll's son Dan, 31, expressed interest in buying a larger home in his father's neighborhood. Instead of paying 4.5% for a traditional mortgage, Dan borrowed the money from his father at a 4.25% rate. The arrangement also enabled Dan to avoid paying closing costs, appraisal fees and other expenses charged by a traditional lender, Driscoll says.
Family mortgages work, Driscoll says, "if your children are honest, trustworthy and responsible."
If financing a family mortgage was a savvy strategy in 1991, the logic is even more compelling now. Returns from the types of low-risk investments favored by retirees are tiny: The average rate on a one-year certificate of deposit is 0.4%. Mortgage rates also are at record lows, but tight lending standards have made it impossible for many young home buyers to take advantage of them.
For Baby Boomers who are unwilling to risk their money in the stock market, financing a child's mortgage "is an opportunity to create a win-win," says Timothy Burke, chief executive of National Family Mortgage, a company that sets up and services intrafamily loans.
To date, National Family Mortgage has helped families finance more than $12 million in loans, ranging from an $18,500 down payment to a $1.17 million refinancing.
Jie Jiang, 33, and his wife, Natalie Leong, learned how tough the lending market has become when they applied for a loan to buy a condo in Los Angeles.
Leong recently graduated from medical school and has started her medical residency atUCLA, while Jiang is pursuing a post-doctoral fellowship in biomedical engineering. The couple had enough money for a 20% down payment but were rejected for a loan, Jiang says.
"Before the financial crisis, (banks) were giving everybody a loan," Jiang says. "Now, unless you have a 9-to-5 job, they won't bother with you."
One bank officer suggested that they get one of their parents to co-sign the loan, but that would have resulted in a mortgage rate of 5% to 5.25%, Jiang says. So instead of co-signing, Leong's father offered to finance the loan. With help from National Family Mortgage, they set up a 30-year mortgage with a 3.85% interest rate. The couple moved into their condo in August. Based on their expected future income, they plan to pay off the loan in 10 years.
Burke says intrafamily loans have enabled some of his customers to make all-cash offers, an important advantage in the increasingly competitive market for foreclosed properties. "They were getting beaten to the punch by other cash buyers," he says.
Banks need to get approval from several parties before selling a home in foreclosure, and a cash offer makes the process much easier, he says. In addition, they don't have to worry about whether the buyer will qualify for a mortgage, says Erin Lantz, director of Zillow Mortgage Marketplace, an online mortgage-shopping site.
When 'gifts' are loans
Most parents don't have the wherewithal to finance an entire home purchase for their children. But even parents of modest means may be able to help their kids come up with a down payment, and many do.
Erin Attardi, a Realtor in Sacramento, recently closed a sale for a young couple who received $20,000 from their parents toward the down payment and closing costs. The couple relocated from San Diego and recently had their first child, Attardi says.
The gift allowed the couple to take advantage of soft housing market prices and record-low interest rates, Attardi says. "In a few years, we don't know what interest rates will look like, and prices in Sacramento don't have anywhere to go but up from this point."
Increasingly, borrowers need to come up with a 20% down payment to qualify for the lowest interest rates on mortgages. In some cases, they may need a down payment of 20% or more to qualify for a mortgage at all. The Center for Responsible Lending estimates that it wouldtake a typical household 14 years to raise enough money to meet that requirement.
In 2010, 9% of first-time home buyers who made a down payment received a loan from a relative or friend, up from 6% in 2009, according to the National Association of Realtorsannual Profile of Home Buyers and Sellers. Twenty-seven percent said they received a gift from a friend or relative, up from 22% in 2009.
Burke believes that a significant percentage of those "gifts" were actually loans. "I have a hard time believing 27% (of home buyers) got a no-strings-attached gift," he says.
Home buyers who borrow money for the down payment may have trouble qualifying for a mortgage. Lenders fear the obligation could prevent borrowers from making their mortgage payments. Many lenders require borrowers to provide a letter attesting that the money doesn't have to be repaid, Attardi says. The lenders also may require borrowers to show that the gift came from a family member, Attardi says.
Short of prohibiting gifts, though, there's no way for lenders to prevent borrowers from quietly repaying parents or other family members who help them with their down payments, Burke says.
Such subterfuge isn't necessary for some types of mortgages, Burke adds.
The Federal Housing Administration, which insures mortgages that are popular with first-time home buyers, allows buyers to borrow funds for their down payments from their parents or grandparents. National Family Mortgage has structured several family down-payment loans for FHA-insured mortgages, he says.
Risks and pitfalls
When Dan Driscoll proposed a family-financed mortgage 20 years ago, his father was in favor of the idea, but his mother had qualms. She was afraid he wouldn't be able to repay the loan.
Those concerns were unfounded. Driscoll not only repaid the loan, he did it in seven years. However, parents who decide to finance a child's mortgage — or take the less-costly step of lending them money for a down payment — need to consider the possibility that their child will default. That could lead to some uncomfortable Thanksgiving dinners.
"If it doesn't go well, that's not something you can walk away from," says Bill Emerson, chief executive of Quicken Loans. In addition, he says, parents don't have the same remedies in the case of default as a traditional mortgage lender.
Loss of flexibility is another drawback to a family-financed mortgage, Lantz says. "You're locking up a pretty big chunk of cash in an illiquid investment asset."
Some parents may be better off getting their own mortgage, buying a house and renting it to their children, Lantz says.
While interest rates for investor-owned properties typically are higher than those for primary residences, they're still at record lows, she says. Lenders on Zillow Mortgage are offering rates as low as 4.375% for investor-owned properties, vs. 3.75% for owner-occupied residences, she says. This strategy would let families take advantage of a soft housing market and low interest rates without tying up all of the parents' cash, she says.
Parents who decide to finance a child's mortgage or help with the down payment also could run afoul of the IRS. Potential problems:
•Gift taxes. Federal gift taxes are designed to prevent wealthy taxpayers from escaping estate taxes by giving away all of their money before they die. In 2011, taxpayers can give away $13,000 per person without worrying about gift taxes. A married couple can give away $26,000 per person without filing a gift tax return.
Taxpayers who exceed that amount must file a gift tax return and the amount will be counted toward the total they're allowed to give away during their lifetimes, tax-free. For estates of individuals who die in 2011 or 2012, the lifetime exclusion is $5 million; however, that amount could fall back to $1 million in 2013.
The easiest way to avoid gift tax problems is to stay within the annual exclusion, which is expected to remain at $13,000 in 2012.
•A loan with terms that are too generous. A loan can trigger gift tax problems if the interest rate is less than the government's applicable federal rate (AFR) at the time of the loan. The IRS adjusts short-term, medium-term and long-term AFRs monthly. For October, the long-term AFR, which applies for loans of more than nine years, is 2.95%.
•Missing out on tax deductions. Interest paid on an intrafamily loan is tax-deductible as long as the loan is registered with a government authority. An attorney can draw up the appropriate documents, or families can pay a company such as National Family Mortgage to do so.
Driscoll hired an attorney to prepare the documents for his son's mortgage and file them with the county courthouse. Financing a mortgage for a child "isn't a risk-free thing," he says. "But it's an option people should consider."