It’s an appealing thought: Why borrow hundreds of thousands of dollars from a faceless financial institution when you can sidle up to family for a home loan?
Whether you’ve hit a brick wall when it comes to qualifying for a mortgage or you’d simply prefer to cut out the bank and go a more nontraditional route, a private mortgage is a solution many turn to. But like any money matter, it comes with drawbacks and potential pitfalls.
How does it work?
Instead of meeting the qualifications of a traditional mortgage, and paying the fees and closing costs that go along with such a transaction, you borrow the money from a person who already has the funds readily available.
The terms of the agreement — interest rate, payment schedule, down payment, and collateral for the loan — are up to the parties involved.
If done correctly, both parties can benefit. The lender can receive a better rate of return for their money, as well as a steady income stream, while the lendee can receive a lower interest rate and greater flexibility with the loan terms.
On the other hand, adding this business aspect to a relationship — even if you’re just borrowing from the “Bank of Mom and Dad” — can place a huge strain on both parties, especially if one side isn’t adhering to the agreed-upon terms.
And of course, if things really go awry, your friendly family lender is on the hook for something far greater than most are financially able to shoulder.
When should you consider a private mortgage and what should you look out for?
First and foremost, the relationship between the consenting parties needs to already be based on trust — trust that both the terms will be fair and the payments will be completed as agreed upon.
When you enter into a contract (of any kind) with family, it’s important to note that the structure of the agreement should be as businesslike as possible.
In addition, it’s essential to consider the ability of the lendee to pay back the money, and the ability of the lender to stay financially stable if the loan isn’t paid back on the agreed-upon terms. Without these assurances, a family-backed private mortgage might not be the way to go. In fact, it might be downright disastrous.
If, however, you are considering a private mortgage through an independent company or individual, there are other concerns to keep in mind.
Oftentimes, loans from private investors or private lending companies come with a high interest rate and a short payback period. So while this may be attractive to the fix-it-and-flip-it crowd, the terms are likely far less favorable for most buyers interested in a traditional 30-year loan from a bank.
Be sure to explore all your options. Talk to traditional lenders and explore alternative solutions before you make the final call.
Tips for smoothing out the process
You’ve run through your options, weighed the pros and cons, and evaluated the potential family drama — and a private mortgage still seems like your best option. Now it’s time to formulate a plan; here are a few ways to make the process run as smoothly as possible.
1. Collaborate on the home-buying process
If your family is agreeing to back you on a loan, they likely are already invested in your home-search process. Help them see what homes or types of homes you are considering by utilizing Trulia’s new home boards. You can share properties in real time for a truly collaborative experience.
2. Get the proper documentation from professionals
Put everyone’s mind at ease by getting the help of professionals (attorneys, your CPA, etc.) to spell out the terms of the agreement. Make sure to have both a promissory note and a deed of trust.
3. Create a payment schedule
A traditional mortgage comes with a payment schedule, so a private mortgage should as well. This will ensure both parties are fully aware of when payments will be made and when the loan will ultimately be paid off.
Is a private mortgage right for you?
The thing is, most people who have successfully navigated a private mortgage agreement are quick to tout its benefits. Just make sure you look at the decision through both a financial lens and a relationship lens before taking that leap.