The Perfect Economy for Intra-Family Loans

While everybody is bemoaning this terrible economy, it has created some outstanding opportunities. One excellent opportunity is in the area of intra-family loans. Federal law requires that loans of more than $10,000 between family members must carry a minimum interest rate known as the ‘applicable federal rate’ (AFR). This rate is re-set and published each month (Google ‘Applicable Federal Rates’). Let’s look at a couple of examples of how you can use the current state of the economy to your advantage:

  1. Your son (or grandson) has a $200,000 mortgage with a relatively high interest rate, say 7%. He would like to refinance but doesn’t qualify because his credit score falls below what the mortgage company requires or the home’s value has fallen to the point where refinancing is not possible. You have a $200,000 Certificate of Deposit maturing and the 5-year reinvestment rates are 3.5%. Instead of reinvesting your CD at 3.5%, you create a first mortgage at 4.5% for your son. As a result, his mortgage payment drops from $1300 per month to $1,000; a 30% savings of $300 per month or $3,600 per year. You receive an additional $2,000 per year in interest so the total family benefit is $5,600. Your money is secured by a first mortgage on the home. If you used this same strategy to provide mortgage financing for a child or grandchild’s first home purchase, he or she could receive federal tax credits of up to $8,000! These tax credits are part of the Obama economic stimulus package and expire December 1, 2009.
  2. If, in our example above, you did not need the cash flow from your funds, you could have created a mortgage based on the lower Applicable Federal Rate of 0.75% using the short-term rate; 2.05% using the mid-term rate; or 3.58% using the long-term rate.   Which rate you must use is determined by the term of the loan. The short-term rate applies for loans of 3 years or less; mid-term rate applies to loans exceeding 3 years up to 9 years; and the long-term rate is for loans exceeding 9-years. If you wanted to minimize the interest rate but anticipated a longer-term mortgage for your child, consider using a 30-year amortization with a 3-year balloon with plans to‘re-write’ the mortgage for successive 3-year terms, before you take the loan, check what loans you can get from them. The risk is the AFR may rise over time.
Intra-family loans can be used for any purpose. For example, you could loan a child $100,000 at the current short-term AFR of 0.75% and she could invest in a 3-year CD at 3%. After paying you $750 in interest, she nets $2,250 before income taxes. For the more adventuresome, the family member could invest in a basket of dividend-paying stocks yielding at least 0.75%; use the dividends to pay your interest and reap the profits when the stock market rebounds over the next three years. Business owners could use this strategy to loan money to a child to buy company stock at a time when values are depressed. When the economy (and company) recovers, you will have efficiently transferred significant wealth with minimum taxes.
The Internal Revenue Service looks closely at intra-family loans so it is important that I know where can I get a loan with bad credit and observe proper loan formalities.