The Bank of Mom and Pop: The Benefits Afforded by Intrafamily Lending
Sometimes skipping the costs and hassles of commercial bank loans can make perfect sense, saving the borrower some money and helping the lender with their estate planning goals.
![](https://cdn.mos.cms.futurecdn.net/RiUdoeDx9mRJPJJymaSADE-415-80.jpg)
She’s done all the right things: She’s worked hard in school, earned an advanced degree and has laid the groundwork toward finding a job in a well-paying career. Impressive as this recent graduate’s successes are, banks aren’t in the habit of giving mortgages to the unemployed.
So why not remove the bank from the equation?
A popular workaround when someone without enough cash on hand is looking to make a major purchase is an intrafamily loan, where a parent or other family member lends money in a formally structured agreement. These types of loans come without the hurdles of those offered by a bank, and there can be other tangible benefits as well, including lower interest rates, versatile payment options and estate planning opportunities related to how the loan is structured.
![https://cdn.mos.cms.futurecdn.net/hwgJ7osrMtUWhk5koeVme7-200-80.png](https://cdn.mos.cms.futurecdn.net/hwgJ7osrMtUWhk5koeVme7-320-80.png)
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
These benefits come with the common drawbacks inherent to lending money — no matter how closely related the parties are, there is always an element of risk — but a well-rounded understanding of intrafamily lending can potentially provide significant upside for both parties. And oftentimes, intrafamily loans can make sense even when the recipient has a job that pays well or another source of income.
Just helping out
The types of loans implemented in intrafamily lending don’t necessarily have to be in the family. In fact, anyone can lend to anyone, any amount, for any number of reasons, from an aunt helping a niece secure a new vehicle, to a friend helping another with capital to help start a business, to a grandparent establishing a trust to provide for a grandchild while moving assets outside their taxable estate.
Smaller loans don’t necessarily have to be structured the way a regular bank loan is. If the amount is small enough — say, $10,000 from a parent to help pay off a child’s vehicle — the lender can simply transfer the funds and allow them to be qualified as a gift. Because the amount is below the $15,000 gift tax exclusion threshold for individuals ($30,000 for married couples) there would be no associated gift tax due, assuming that total gifts for the year do not exceed the annual exclusion.
Carrying the full load
A common, and more complicated, form of intrafamily lending is a mortgage. Let’s say our overachieving-yet-cash-strapped grad wants to buy a $300,000 home. Unless she has already landed a good job and squirreled away enough savings for the down payment, the bank isn’t likely to be interested in lending to her. But if her parents have the means, they can loan the child a portion of the mortgage, or the entire mortgage amount. With the guidance of their financial adviser and an attorney, the parents can construct a home loan with advantageous terms for their family — one with no money down, no pre-approval, no credit check and no background check. The child is just getting a loan from the “Bank of Mom and Pop.”
Perhaps the best part of this arrangement is that the interest payments stay in the family and will likely come back to the borrower one day as part of their inheritance. But in the short-term, the interest rate they will be paying will not only be lower than those on mortgages from commercial banks — it will be the lowest rate allowed by the IRS. As of July 2019, the compound annual applicable federal rate (AFR) is 2.13% for a short-term period (three years or less), 2.08% for mid-term loans (more than three years on up to nine years), or 2.50% for a longer term (more than nine years).
Crafting loans
When drawing up a loan with your attorney, there are several key considerations and procedural steps to take. If the loan is a mortgage, the lender needs to create a promissory note and file the mortgage within their county to make it official. In this, intrafamily mortgages are different than other types of loans.
Two of the most important factors when designing the loan is making sure it stays distinct from a gift. Lenders can do this by establishing it with an interest rate based on the current AFR and setting up an appropriate payment structure. Failure to do so may bring scrutiny from the IRS, leading to a potential penalty or a gift tax being imposed. And, just to be clear, the gift tax would be owed by the person who gave the gift, not the one who received it.
Tips on structuring the loan: I typically recommend to my clients that they make their mortgages interest-only, with a balloon payment scheduled for the end of the loan’s term. If at the end of the loan the lender wishes to refinance, they of course have the option to do so. Likewise, if the recipient is unable to keep the payment schedule, the lender may decide to forgive the interest at the end of each year. Again, the lender could use their annual gift tax exclusion to forgive the required payment without money being exchanged and the IRS would consider the payment “made.”
It’s worth noting that for a loan recipient to pay down the principal, they are really just shifting cash back to the lender’s estate, and they probably don’t need the money if they’ve just lent the child hundreds of thousands of dollars. Another way to look at is it that the recipient of the loan is also likely going to inherit a portion of the lender’s estate. So, they might they ask themselves, who will benefit more from the incremental cash they would apply to principal, the younger version of themselves just starting out, or the future version, who is more established in their career and is a beneficiary of the lender’s estate?
Intrafamily loans can provide families a simplified way to make complex purchases, with more flexibility and favorable terms compared with what they would get from a traditional bank. The key to making such a solution work is to align the structure of the loan with the financial means and goals of both parties, and to manage the note and all related payments and documentation in accordance with regulatory requirements.
Get Kiplinger Today newsletter — free
Profit and prosper with the best of Kiplinger's advice on investing, taxes, retirement, personal finance and much more. Delivered daily. Enter your email in the box and click Sign Me Up.
Casey Robinson is the Managing Director of Wealth Planning at Waldron Private Wealth, a boutique wealth management firm located just outside Pittsburgh. He focuses on simplifying the complexities of wealth for a select group of individuals, families and family offices. Robinson has extensive experience assisting multi-generational families with estate planning strategies, integrating trusts, tax planning and risk management.
-
Visa Is the Worst Dow Stock Wednesday. Here's Why
Visa stock is down sharply Wednesday after the credit card company came up short of revenue expectations for its fiscal Q3.
By Joey Solitro Published
-
Another Analyst Moves to the Sidelines on Tesla Stock After Earnings
Tesla stock is spiraling Wednesday after the EV maker's big earnings miss and Wall Street has been quick to weigh in. Here's what you need to know.
By Joey Solitro Published
-
Confused by Annuities? Making Sense of the Different Types
Many investors aren't sure if annuities are a good option for meeting financial goals. Let's look at the different categories, along with their pros and cons.
By Kris Maksimovich, AIF®, CRPC®, CPFA®, CRC® Published
-
Talkin' 'Bout My Generational Wealth: Baby Boomers
With retirement, each generation has different priorities and challenges. For Baby Boomers, it's a matter of ready or not, here it comes.
By Alvina Lo Published
-
How to Avoid a Big Hassle if Your Financed Car Gets Wrecked
How an insurance check is made out for repairs can cause a world of problems if the lienholder is left out.
By H. Dennis Beaver, Esq. Published
-
Estate Planning Strategies to Consider as Election Nears
Are big changes in tax laws coming soon? Not likely, but you might want to take advantage of higher estate and gift tax exemptions well before the end of 2025.
By David Handler, J.D. Published
-
How to Get Your Money's Worth From Your Financial Adviser
A good financial adviser will focus on how your financial planning and investment strategy align with your lifestyle and aspirations.
By Pam Krueger Published
-
Think of Prenups and Postnups as Financial Planning Tools
These contracts provide a clear framework for asset management and protection and are especially useful if you get married later in life.
By Andrew Hatherley, CDFA®, CRPC® Published
-
Congratulations on Your Raise: Three Things to Do With It
We're not saying you shouldn't spend it on a new car, but there are some considerations to guard against lifestyle creep and to help ensure a comfy retirement.
By Andrew Rosen, CFP®, CEP Published
-
Check Off These Four Financial Tasks to Finish 2024 Strong
The new year is a popular time to set financial goals, but now is the ideal time to check how you're doing. Four tweaks could make a big difference.
By Daniel Razvi, Esquire Published