There are banks on just about every corner in the event you want to borrow money to buy a house, but not every person can qualify for a mortgage. A person may have just come out of a financial hardship and unable to obtain bank financing or refinancing for a house. A self-employed individual does not have W2 forms nor a steady income that lenders like. Young adults are still building their credit scores. There are a myriad of reasons a person’s finances do not look the way a bank wants them to look. Banks look at credit score, payment history, ability to make future payments and collateral when reviewing a loan application. Some borrowers, for whatever reasons, just can’t meet the stringent requirements of a bank. Even though a potential borrower may be more than able to repay the loan, banks have specific criteria and rarely waiver in their requirements to qualify a borrower. But, there are alternatives to obtaining a loan for a house. One way is with a private mortgage.
What is a Private Mortgage?
The concept of a private mortgage is not very well known in this country. It is money that is lent to you by friends, family, or other private sources. The term “private” means the mortgage is not coming from a bank, mortgage broker or a financial institution, but is coming from a private arrangement. There are private mortgages that come from persons the borrower does not know, which are called hard money loans and not discussed in this post. The focus of this blog post is loans from and to friends, family and acquaintances. For instance, if a parent wants to sell their house to an adult child who does not qualify for a bank mortgage due to student loans or recent employment, the parties can finance the purchase and sale with a private mortgage. The parent would finance the sale by loaning the adult child the money, and the adult child would agree to the loan with a mortgage securing the home in the event the child ever defaults on the loan. The parent enjoys a steady stream of income until the loan is paid off and the adult child enjoys a custom-tailored loan with a low interest rate using the house as collateral. Or, if the parent has a self-directed IRA, the parent may be able to loan money from the IRA as an investment.
Get it in Writing
Now, I know the old axiom of never loan money to friends and family, and believe me, I have been burned a few times from it. But if you get a well-documented written agreement between the borrower and lender there should be no disagreement of what is owed and when it is owed. With a private mortgage, if you are either a borrower or a lender, you negotiate the terms of the loan agreement. The agreement sets the interest rate (make sure the interest rate is within the IRS guidelines), the terms, prepayment, collateral (usually, the house), other terms agreed to, and what to do if there is a default, e.g., foreclosure. The terms are customized to fit both the borrower’s and lender’s wants and needs. Even though this is a loan between friends, family or acquaintances, every aspect should be covered in the loan agreement. Imagine what could go wrong if the loan was over a period of 30 years, and then imagine what you would do if it was not in writing. So, when the loan agreement and collateral come into play, both the borrower and the lender should rely on experts to help them through this part of the process. An attorney would be able to prepare the documents and advise on state law, a financial planner would be able to advise in the event the lender wants to use a self-directed IRA, and an accountant would be able to discuss tax deductions and appropriate interest rates. The process is really not that difficult once the lender and borrower agree on the terms.
A private mortgage with family and friends can be a beneficial situation for all involved. Borrowers typically save money by paying relatively low interest rates and can customize the terms of loan, and lenders who have extra cash on hand can earn more interest on the loan than what is paid on a CD or savings account. There are, however, risks to the relationship between the lender and borrower. So, before signing up for such a substantial commitment of being either a lender or a borrower, make sure it’s in your best interests – financially and emotionally.