As families gather for the holidays, some adult children or their parents will broach the topic of real estate and how to make that first home purchase.
For parents who have the funds and desire to help adult children buy a home, gifting a down payment is one of the most common ways to help. But it’s not the only option.
Here’s a look at several ways parents can assist their children in becoming homeowners.
Gifting a Down Payment
For an owner-occupied property (not an investment property), mortgage lenders typically allow borrowers to use money gifted from a family member as a portion of the down payment. However, if it’s a recent gift, the borrowers must be able to prove the origin of those funds and provide a letter affirming that the money is a gift and does not need to be repaid.
Bob Collins, a mortgage broker with Signal Hill Mortgage in California, says parents gifting a down payment often treat it as “here’s your inheritance in advance,” so they can see the benefit of that money during their lifetime.
This approach puts the gift-giver under some scrutiny with the lender, but not nearly as much as other options. “All we have to do is verify that they have the funds to give, and we get a gift letter,” says Greg Cook, a mortgage consultant in Southern California. “Then they send the money to the settlement agent, and as long as it matches up with the gift letter, we’re good to go.”
If the gift exceeds the Internal Revenue Service’s annual gift tax exclusion of $14,000 per recipient per year, then it may require extra tax paperwork. However, a married couple could each give $14,000 to a child and a child’s spouse, for a maximum of $56,000 in four separate gift checks.
Offering a Family Loan
Given the current low interest rates on savings vehicles such as certificates of deposit, or CDs, relatives with cash to spare might choose to loan money to a family member to buy a home in lieu of the buyer getting a traditional mortgage. “It’s a win on both sides,” says Dan Yu, managing principal of EisnerAmper Wealth Advisors in New York. “If Mom and Dad went to the bank and said, ‘What will you pay me for a five-year CD?’ If the son or daughter went to the bank to try to borrow on a 30-year mortgage, they might have to pay 4 percent. Both sides of the family win, and mom and dad are earning a higher interest rate [than they’d get from a CD].”
However, as Yu points out, “it’s not just Mom and Dad, but rich aunts and uncles do this as well.” Assuming the lending relative has the liquidity to make the loan and is prepared to do so, the homebuyer would be able to make an offer not contingent on financing and potentially offer the seller a quicker closing, which could be an asset in competitive markets where all-cash offers are the norm.
One thing to remember with family loans is that it still needs to be at arm’s length, meaning it follows the IRS’s proscribed interest rates based on the term of the loan.
If earning interest isn’t the goal, the relative giving the loan could choose to forgive up to $14,000 in interest per year under gift tax exclusions ($28,000 if they’re lending to a couple). Otherwise, lenders have to report interest payments as taxable income, just as they’d report interest from CDs or money market accounts. Borrowers can deduct mortgage interest (assuming they itemize their tax deductions) just as they would with a traditional mortgage.
Co-signing the Mortgage
In cases where an adult child’s income is too low to qualify for a mortgage on the home they want, having a parent co-sign the mortgage might help. If they can afford to take on the obligation, some parents may prefer this option if the alternative is their child buying in an area they consider unsafe or undesirable.
However, co-signing is a bit of misnomer in this case. “They’re really a co-borrower, and they’re in the deal as much as the kids are,” Cook says. “They’re under the lender’s microscope to the same extent: income, credit, current debt load, all the things that we look at for the kids.” If the child’s income is sufficient to qualify for the remaining balance on their own in the future, the loan might be refinanced in just his or her name to relieve the parents of liability.
One potential downside for parents is that the mortgage will show up on their credit as an outstanding loan obligation, which could complicate refinancing or buying another home in the future. “They’ve created an obligation for themselves that could limit anything they might want to do moving forward,” Collins says. Also, if the child misses mortgage payments, that will also impact the parents’ credit.
With all these options, you should consult a financial advisor first to make sure you can comfortably afford to help without jeopardizing your financial security. You may also want to consult your tax preparer about potential tax implications, and, depending on the circumstances, ask a lawyer how to structure the legal paperwork in case your child divorces or defaults on the loan. Nobody plans on things going awry with real estate transactions, but it can happen, so it’s best to be prepared.