Buying a home with family mortgage - our experience

[gbbi_977]

In case this is of interest to anyone...

We just bought our first home, a condo actually, and after qualifying for a mortgage with the bank (for twice what we actually spent) at 3.75%, we decided to get a mortgage from my father-in-law (for 3.5%).

- FIL was looking for an investment opportunity
- all interest paid gets kept in the family, rather than going to the bank
- lower interest rate
- because mortgage was 'private', the transaction was treated as a cash deal at closing - meaning seller split the closing costs (apparently that's the convention for cash deals, at least in our state)
--> overall very low costs - our attorney drew up the mortgage/note for $450, and is registering it - LTI/appraisal not required - our total closing costs, on $235K purchase, were under $2300 including attorney fees and home inspection

This was also FSBO, which was helpful in negotiations with seller.

[Roots&Wings]

Thanks so much for sharing this! A couple follow-up questions:

1. How will you (and FIL) be handling the interest reporting for tax purposes?

2. Which IRS table or resource did you reference to ensure the lower interest rate was market-rate and not considered a gift?

[Weedy Acres]

I've done intra-family mortgage loans before, on both sides.  As for the recordkeeping, I keep a spreadsheet and then use provide the year-end tally to the other party, via an email that says "here's your 1099" or "here's your mortgage interest statement."  I put the appropriate numbers on my own tax returns, and presumably those on the other side do the same.

[TheOldestYoungMan]

This is how I did my last home purchase.  The attorney that drew up the papers also gave us a spreadsheet that shows the interest paid each year, as long as we stick to that payment schedule.

The IRS publishes an interest rate (each month? quarter?) based on duration of loan that you have to have to not be a gift, so we used that.  So the reduction in interest is pretty cool ( I want to say it was 1.9% at the time, and the best quote I got from a bank was 2.9%), but also keeping the money in the family.

There's two things that I was wary of.

1.  Involving my father in my finances in any way.  I had a very long and very frank conversation with him about the limits of this deal.  It's a structured debt/payback plan, and he's free to call a collections agency if I don't pay on time.  He is not free to in any way shape or form comment on my spending or lifestyle in the context of "owing him money."  One word and I dump the deal and go through a bank.

2.  Taxes.  The taxes end up working out the same, I just have to fill out a form for the interest paid, because dad doesn't really send me anything.

One thing that didn't work out that great, I had a hard time setting up an automatic deposit to another account with my bank.  They are cool with sending a check through online bill pay, but that was an extra errand for dad every month.  It probably took two months of arguing with the bank to get it set up, and of course, everytime we talked about it they were trying to convince me to get a mortgage through them instead.  It is all set up now, and it is way more awesome to send that money to my parents every month instead of the bank.

My parents had both retired recently and were just sitting on a pile of uninvested cash.  It was killing me seeing market returns upwards of 10% while they did nothing.  But from their point of view, they had done well by not being in during the 08-09 debacle.  I look at it like managing my own inheritance.  It's a similar situation to me paying cash for my house, and then directing the parent portfolio, only I get to deduct mortgage interest at a higher rate than they have to pay taxes on.

I also only did this when I had enough assets to be able to buy out the mortgage if it ended up negatively affecting our relationship.

There were alot of savings at closing, I'm comfortable enough doing a home inspection on my own that I didn't have to pay for that, didn't have to worry about appraisal or anything else either.  Got to skip the whole loan paperwork thing, but I did pull a copy of my credit report for dad to see.

The loan is all registered in the right places, everything is legit, all the benefits of a mortgage with none of the bank bullshit.  No fee for waving escrow, and I was able to get reasonable insurance amounts for the house, not having to cover the full price of the note.  It was quick too, I could get feedback from my lender within seconds as opposed to weeks.  I would absolutely have missed out on my home if I'd been going through a bank.

One thing I didn't think about at the time, but my sister pointed out later, is that in the event of my parent's death, because of how they set up their will, I won't owe my sisters money, I'll owe it to my nieces and nephews.

Which is a scary thought.  I don't know what it's like to owe a hundred thousand dollars to a 4 year old girl, but I imagine the terms could turn dictatorial with the quickness.  Ice cream addendum.  Dance-recital riders.  Late fees on birthday presents.  Notary public signatures required on tea party meeting minutes.

[waltworks]

No effing way would I involve my family in a real estate financing deal for a measly .25%.

Good luck.

-W

[waltworks]

I have been involved in one. Disagreements quickly popped up (interest rates dropped, we wanted to refinance - family wanted to keep their interest money coming in, then we wanted to move and that created another set of arguments about whether we should sell the house or keep it as a rental, etc) Everything was agreed upon, documented, and legal - but our interests quickly diverged and now we are no longer on speaking terms with a close family member because we sold the house.

I mean, if your FIL can get 8% on t-bills in 5 years, is he going to still be happy with his 3.5%? Or will it hang over every interaction?

Family/friends and large amounts of money just shouldn't mix, in my experience.

-W

[waltworks]

Our situation was initially conceived as a mutual benefit thing, not a "favor". C'est la vie.

I think this is a Pascal's wager problem. It's unlikely that there will be an issue (though if inflation goes nuts your FIL might not be too happy with his 3.5%...). But if there IS a disagreement or financial problem/default/whatever, it is almost certainly going to be catastrophic for the relationship.

So it's low reward (FIL could just buy REITs or bonds if risk averse, you aren't saving much of anything) and high risk. Better to do your high-stakes financial deals with disinterested third parties, so if you run into problems there's no personal relationship at stake.

-W

I have been involved in one. Disagreements quickly popped up (interest rates dropped, we wanted to refinance - family wanted to keep their interest money coming in, then we wanted to move and that created another set of arguments about whether we should sell the house or keep it as a rental, etc) Everything was agreed upon, documented, and legal - but our interests quickly diverged and now we are no longer on speaking terms with a close family member because we sold the house.

I mean, if your FIL can get 8% on t-bills in 5 years, is he going to still be happy with his 3.5%? Or will it hang over every interaction?

Family/friends and large amounts of money just shouldn't mix, in my experience.

-W

Thanks for sharing your experience - greatly appreciated! And I'm sorry to hear it went so sour for you. Of course, I can't guarantee something similar won't happen in our situation, but I'm hoping our experience will be different. You obviously did the same due diligence as us, so I guess I'm just hoping we'll be luckier than you.

Just curious - when you negotiated this mortgage, was the vibe sort of 'we're doing you a favor' or was it more 'this is mutually beneficial'? I'm hoping fact that ours was the latter (in fact, in-laws actually brought the idea up as they are wary of investing in stock market, having been burned in the past) might mean the dynamic at play here is somewhat different.

Which is not to say I'm naive about the potential for things to get ugly...but really hoping they don't! Any other tips on how to prevent disagreement down the line gratefully received.

[TheOldestYoungMan]

Yea, I agree with everything waltworks pointed out.

My disgust with banks and how they handled my previous mortgage was the primary motivator.  Both parties need to be in a particular state of mind to think this is a good idea, and they need to stay that way.  I think it's a good idea to have an out as well.  Like I said, if I didn't already have enough assets to buy out the mortgage I wouldn't have done it.

[supomglol]

Great topic!
We did this last year with my Parents.  When my mother moved to another town about 30 minutes away to be closer to her job a few years back I moved into their "old" place with a long term plan of rehab first - purchase second.  They didn't need the money and weren't completely ready to sell.  We talked off and on about the purchase timeframe and price.  At one point we even paid an attorney to write up a purchase contract (~$250).  But we never followed through.

Late last year we got our shit together, negociated a price based on recent sales of similar condition/size houses in our area; and chose an interest rate of 3% (the same I was approved for from my bank).  Since this was their house, and they didn't need the cash upfront; they agreed to carry the note for us in exchange for a little interest income.  I used a realator friend of mine to draw us up a new contract, and we forked over 33% of the purchase price and created an excel amortization schedule spreadsheet for the 15-Year loan on the remainder. 

I use my bank's online billpay function to automatically mail the payment each month to their house.  There was a bit of an initial disagreement with them regarding the sale price, but that was more of a result of my father not wanting to sell the property at all and not so much about the price.  We showed them our research of recent and pending sales within 1/4 mile and he reluctantly agreed.  I don't know if we really got "a deal" but it has worked out well for both parties so far.  We are about to make our 5th payment on the 1st of May. 

Now, where this gets tricky financially speaking is when you talk about extra payments.  From an analytical standpoint extra cash would be better invested in Index Funds earning ~6-7% rather than used to pay down a 3% mortguage.  You might be thinking, yes!  But if we invested all our extra money rather than making extra payments on our house; we may earn lets say $1,000 extra in interest in an investment earning 6% rather than an effective 3%.  When you're dealing with a family loan, you are really just stealing that money from your lender; since if they had not loaned you the money they could have made that 6% investment themselves instead of investing in your 3% mortguage return.  For that reason, we will be putting every spare dollar toward our house payment rather than investments for the forseeable future.  Plus, my wife says she feels a bit like we are under their thumb since we owe them money; I've never heard a word from them about it - but they are my parents not hers.

I hope to have the house paid off in the next 7 years or less. 

[supomglol]

Now, where this gets tricky financially speaking is when you talk about extra payments.  From an analytical standpoint extra cash would be better invested in Index Funds earning ~6-7% rather than used to pay down a 3% mortguage.  You might be thinking, yes!  But if we invested all our extra money rather than making extra payments on our house; we may earn lets say $1,000 extra in interest in an investment earning 6% rather than an effective 3%.  When you're dealing with a family loan, you are really just stealing that money from your lender; since if they had not loaned you the money they could have made that 6% investment themselves instead of investing in your 3% mortguage return.  For that reason, we will be putting every spare dollar toward our house payment rather than investments for the forseeable future.  Plus, my wife says she feels a bit like we are under their thumb since we owe them money; I've never heard a word from them about it - but they are my parents not hers.

Very interesting point, thanks! So interesting that I posed it to DH, who wrote this response - curious to hear your thoughts!

Index funds still comprise stocks and bonds and are subject to market volatility and the associated risk.  The family mortgage by comparison is a very safe investment and at 3.5% it is a much better return for the lender than other similarly safe investments like CDs (at least given the rates right now).  So in this case, the investment may be “worse” in that it is delivering smaller returns than the stock market but it is also “better” because it is less risky in the scheme of things- making it a beneficial investment for someone near retirement age who doesn’t want to risk their principal.
 

This is true that the relative risk potential is dependant on the lender's own investment choices.  In our case, since my parents already owned the property free-and-clear they did not have to liquidate any assets to finance our mortguage.  So I think it does make a bit of a difference of where the lender is getting the money from; in another example family may have cashed in higher-earning investments to finance the loan. 

Also, in the context of a family loan, paying additional principal is also “stealing from your lender” because each additional payment of principal decreases the interest on the next payment and thus the lender’s overall rate of return.  Paying the additional principal returns the principal to the lender faster and would enable them to invest in something like the Index funds at 6-7%, but if that isn’t in the lender’s investment strategy (which it probably isn’t or they wouldn’t/shouldn’t be lending you the money) then paying down the principal on the mortgage faster is actually worse for both parties.
 

This is also true.  While paying back principle early is technically reducing the income of the loan, you are providing immediate assets to be invested (likely at a higher rate of return) to your lender.  So long as they don't let that extra money sit in a bank account somewhere earning less than 3% interest, it is in their best interest to have the money sooner. 

In either case there are pros and cons for both the lender and lendee- the key is talking about those options ahead of time and making sure both sides are aligned on the contingencies.
 

Absolutely, discussion is the best solution for all parties.  In our scenario extra money from both parties would have been invested in index funds.  So going from 6-7% down to 3% will be a hit from one party whether it be us or them.  But also noteworthy is that the bank will be earning 0% both in interest and fees.  You could argue that both parties would have been better off investing in index funds and getting a loan from a bank at 3% and we all would have come out ahead; but that discounts one intrisic value of a family loan (in the event of a hardship or some other unforseen circumstance, family will likely work with you more than a profit-driven bank would).