What to consider before entering into a home equity loan

At some point, almost everyone has visited one of the most popular lenders: BOMAD – otherwise known as Mom and Dad Bank. Most likely, the transaction took the form of a gift. Maybe it was a few thousand dollars when the oven was on. However, some households enter into more formal lending arrangements using home loans.

With home loans, the lender (usually the parents) either provides the recipient (children) with funds for special use or creates a “grantor” trust to which an heir can draw while the grantor is still alive. When interest rates are low, this can be a cost-effective lending option if it is properly structured to meet IRS requirements.

Domestic Loan Construction

You will generally want to use the Applicable Federal Interest Rate (AFR) for home loans to ensure that the IRS does not view the funds as gifts. There are three levels you need to know: a short-term loan of up to three years, a medium-term loan of three to nine years, and a long-term loan of up to nine years. Be sure to check it out current AFR table for updated prices. If the interest rate charged is equal to or higher than the AFR for the duration of the loan – and the borrower makes payments – you can largely structure the loan agreement as you see fit.

Suppose, for example, that your child wants to take a new path. You could create a short-term home loan with an interest rate of 0.14% (AFR from January 2021) and then set up a payment structure on a monthly, bi-monthly or semi-annual basis. If your child were going to a commercial lender, they would need a minimum credit score. And even then, the interest rate would be higher – and much higher than the market rate when the borrower’s creditworthiness is called into question.

The same will apply to a home equity loan. In this case, you should follow a long-term AFR rate of at least 1.35% from January 2021. Compared to the current national average interest rate of a 30-year mortgage (around 2.75%), it would allow for much lower payments. to buy a home — which, of course, depends on the liquidity of the parents. There are not many people who have so much money to pay such a big bill. The lender’s financial situation will determine if a home loan of this size makes sense.

Protection of the Dynamic Family

While it may be a cost-effective strategy to transfer wealth, home loans are not without its drawbacks – especially around how they can affect family dynamics. It is important to consider what this loan agreement can do for the relationship between not only parents and children but also with the involvement of other family members. Here are some strategies to ensure your home equity loan goes smoothly:

1. Work for justice

Mixing family and money can be dangerous. Domestic loans are no exception, as they can create problems for sibling relationships when the disbursement is not equal. In addition, there may be times when a child becomes dependent on loans to cover mortgage payments, car payments, home improvement projects or even business expenses.

If the other children refrain from using their parents as a secondary source of liquidity, the hostility could very well raise its ugly head. Although home loans offer more flexibility than commercial finance arrangements, you need to be careful when discussing and structuring terms to ensure that the agreement does not lead to relationship issues in the future.

2. Weigh the effects of delinquency or default

Like any other loan agreement, family members often take out home loans on a repayment basis. Even if the agreed terms state that the borrower must make interest-only payments by the maturity date of the loan, there is still an expectation. Consider potential cash flow issues if the borrower were unable to continue paying on the loan.

Would you jeopardize your financial situation? What will happen if your child defaults on the loan? If this were to happen, it would be worth the gift tax if the loan amount exceeded $ 15,000 ($ 30,000 for couples) for the year. Prices can range from 18% to 40%. Therefore, it is advisable to meet with a chartered accountant or tax professional before entering into a loan agreement because of the tax arrangements associated with bad loans and debt relief.

3. Create a paper (or digital) path

It is easy to treat home loans more as occasional deals than with formal contracts. This, however, is a big mistake, as it can lead to failures in documenting the interest rate, the payment amount, the loan terms, etc. Consider, for example, a home equity loan. If the borrower were to use a home loan to buy a home, the loan must be recorded as collateral against that property. This would then allow the individual to deduct the cost of interest on income taxes.

This documentation is also vital for parents, who will need to quantify interest income based on the amortization table during the tax period. Failure to do so could result in the IRS reclassifying the loan as a gift, incurring a gift tax for the lender. Again, consult a chartered accountant or tax professional to avoid any misunderstandings related to the loan and to make sure that all aspects of the loan are documented.

Whether you are lending money to a child or grandchild, a home loan is a formal lender-debtor agreement — and you should treat it as such. Examine carefully what you are getting into and take the time to determine if the agreement makes sense from a relationship perspective and from a wealth planning perspective. Remember: Failure to repay someone could do far more harm than good to your financial future.

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