On Real Estate & More – October 2019

Purchasing a home is typically one of the biggest investments in your lifetime and few people have the cash to purchase a home outright. One option that comes up occasionally, and can work well for everyone, is to get a private loan from a friend or family member. A private loan can work well for both you and the person lending you the money. You get the cash you need; the person loaning the money earns interest at a rate equal to or even higher than they could have gotten from their investments.

Commonly called a “private home loan,” it is not very different than a loan you’d get from a conventional lender. You would normally sign a contract and establish a schedule of monthly repayments with interest. Your private lender will hold a lien on your property and have the legal right to demand full payment on the outstanding balance if you fall behind in making payments. (Note: Unlike in the past, you’ll probably need to find a private lender to fund you the entire amount of the loan — trying to combine a private loan with a traditional bank loan may lead to the bank refusing to lend if you seem to be taking on more debt than you can handle.)

Your private lender can even foreclose if you default on the loan. Although extremely unlikely, it’s important to give them this right, so that if you get into financial trouble and another lender forecloses on you, your private lender will have some recourse.

By turning to a friend or family member, you might gain the following:

  • Borrowing from someone you know can mean a lower-interest loan. That’s because you and your private lender will set the rate (subject to the IRS interest minimum).
  • Your loan repayment terms can be negotiated between you and your private lender. That flexibility can allow you to arrange a loan with an unusual repayment schedule at the outset—such as interest-only payments for the first year—or to temporarily pause payments due to unforeseen circumstances.
  • If done correctly, private loans can allow you to benefit from the federal tax deduction for home loan interest paid.

Your private lender may also benefit in a number of ways:

  • Even without paying as much interest as you would pay to a bank, you can probably offer higher interest than the person could get on current investments.
  • Private mortgages are ordinarily repaid over time as opposed to in one lump sum (unless, of course, you sell your house). By setting up and following a repayment schedule, your payments can become a steady income stream for your family-or-friend lender.

Once your private lender has agreed to loan you money to finance your home purchase, you’ll want to handle the transaction almost as a bank would. This includes drafting and signing a written promissory note and supporting mortgage documents. You would typically provide a written repayment schedule as well.

Promissory note—This is a legally binding document signed by you, the borrower, saying that you promise to repay the loan under agreed-upon terms. These terms, including the interest rate, payment dates, and frequency of payment, should be included in the note. The note should also describe any penalties that the lender can assess if you fall behind in repaying the loan.

Deed of Trust—This is a legal document that secures the promissory note. It says if you don’t pay back the loan, plus all fees and interest, then your private lender can foreclose on your property and use the proceeds to pay off the loan. The deed of trust lists the currently- recognized owner and legal property description and describes the borrower’s responsibility to: pay principal, interest, taxes, and insurance in a timely manner; maintain hazard insurance on the property; and adequately maintain the property. If you fail to comply with these requirements, your private lender can demand immediate, full payment of the loan balance.

Repayment schedule—A repayment schedule is important to document repayment for your family or friend lender.

Some private home loans may fall under the federal Dodd-Frank Act, which is implemented by the Consumer Financial Protection Bureau and governs mortgage lenders. It’s important to get professional or legal help with this, and your real estate broker can work with the title company or an attorney to help you complete these items.