After college, Dan Mazzarini made a beeline for the Big Apple. After working as an interior designer with Michael Kors and Ralph Lauren, among others, he cofounded a business, BHDM Design, in 2012. The following year, a studio apartment came up for sale in Mazzarini’s co-op apartment building in Greenwich Village. Mazzarini, 34, decided to go for it. “That’s how it happens in New York. You don’t have a lot of time to sit and think about things,” he says.
The sellers were asking $550,000. After adding up the cost of the 20% down payment required for co-ops and estimated closing costs, Mazzarini realized that the $50,000 he had managed to save wasn’t enough. He swallowed his pride, called his parents and asked for help. They told him they would be happy to chip in for what they called a great investment and ponied up $56,000. “You’ve never asked us for a thing, and you’ve earned it,” said Mazzarini’s mom, Clare.
Because the apartment was a fixer-upper and the sellers wanted to make a quick sale, they dropped the price from $550,000 to $499,000. Then Mazzarini negotiated the price down to $445,000. With his savings and his parents’ gift, Mazzarini made an $89,000 down payment and paid about $6,000 in closing costs, with the sellers picking up the rest. He used an additional gift from his aunt for renovation.
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Accumulating a down payment and closing costs and qualifying for a mortgage have always been hurdles for first-time home buyers. But lately it’s been tougher for many young people to save enough, partly because of the effects of the recession and partly because of student-loan debt (see Home Price Hikes Take a Breather). Among the benefits of owning a home now: With mortgage rates still historically low (the national average fixed rate for a 30-year mortgage was 3.75% in early March, according to Freddie Mac) and a tax deduction for home interest, a monthly mortgage payment may well be less than you’d pay in rent, given that rents in many cities are high and rising.
Families often extend a helping hand. The National Association of Realtors reported in 2014 that 26% of first-time home buyers received a gift of money toward their purchase, and another 6% received a loan from a family member. But it’s important to help in a way that works for—not against—your child and yourself. For example, a loan will add to your child’s total debt load, which could make him ineligible for a mortgage. You may incur tax consequences with a gift or loan. And if you are a co-borrower, you put your own credit rating on the line.
A Gift That Keeps On Giving
The simplest strategy? Give a gift that your child can use for a down payment, closing costs and reserved savings, if the lender requires them. You can generally provide the entire down payment. But if you give more than $14,000 in 2015, you’ll have to file a gift tax return, and you’ll begin to eat into the estate-and-gift-tax credit that protects up to $5.43 million (in 2015) in lifetime gifts and bequests from the federal gift and estate tax. (Your spouse can also give up to $14,000.) Because Mazzarini’s transaction bridged two calendar years, his parents gave the maximum amount of $28,000 per couple in 2013 and in 2014.
Lenders must try to verify that your gift isn’t a loan in disguise, which would add to your child’s debt load and disqualify him for the mortgage—and they must document the source of gift funds. You must provide a “gift letter,” signed by you and your child, that specifies the amount and transfer date of the gift and states that you don’t expect repayment. The lender will also ask your child for two months of bank statements. If they show a large deposit of funds, the lender will ask you to document its source.
It’s easy to track money pulled from a savings or retirement account. But cash pulled from, say, a home safe can cause problems, says Chris Bennett, of Allen Tate Mortgage, in Charlotte, N.C. He recommends that you deposit the cash in your savings or other account at least 60 days before your child applies for a mortgage.
As closing nears, the lender must also verify that you have transferred the money promised to your child’s account. It will ask for a copy of your withdrawal slip or canceled check and a copy of your child’s deposit slip, or bank statements showing the withdrawal and deposit of funds. With FHA mortgages, as long as you deposit the gift in your kid’s bank account at least 60 days before closing, you won’t need to document the transfer of funds. If you won’t provide the funds until the day of settlement, you must use a certified check, cashier’s check, wire transfer or some other official check.
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The Bank of Mom and Dad
If you would prefer to lend your child the money, the mortgage lender and the IRS will require you to formalize your loan and document it. The loan term can be as short or as long as you like, but the resulting monthly payment plus all other monthly debt repayments (including student loans) can’t exceed the lender’s maximum debt-to-income ratio.
The lender will consider your loan a second mortgage, which you must “subordinate” to the lender’s interest in the property, says Dan Gjeldum, of Guaranteed Rate, a mortgage lender based in Chicago. And you can’t do your child a favor by forgoing interest or charging a superlow rate. For starters, the lender may require you to charge interest at a market rate, and you must establish a repayment schedule. The IRS will also require you to charge a minimum interest rate (the current applicable federal rate, or AFR), which in March was 2.17% for loans with terms longer than nine years. You must report the interest as income, and if the IRS catches you charging a rate lower than the AFR, it could add the interest you should have charged to your taxable income and view it as a gift to your kids.
To document the loan, you’ll need a promissory note and a deed of trust, which secures the loan with the property. That allows your child to deduct the mortgage interest he pays you. And it protects you if your child defaults. (You could foreclose, although you’d be second in line for reimbursement after the first-mortgage lender.)
It takes about an hour of a lawyer’s time to draw up the paperwork, says Paula E. Meyer, a real estate lawyer in Orange County, Calif. If you don’t want to act as the loan servicer, you could use National Family Mortgage to set up, document and service the loan. It will e-mail payment reminders and monthly statements, collect and credit payments, and issue year-end IRS 1098 and 1099-INT tax forms. Cost: a one-time fee of $725 and a minimum of $15 a month for servicing.
Meyer also recommends that you ask the title agent (who may conduct the closing) for a copy of the property’s title report and that you buy a title-insurance policy (about $100 to $400 to cover a $25,000 loan, depending on property location) to protect your interest if an issue arises later—say, an undiscovered lien shows up against the property. If your child refinances the loan later, you must verify payment history for the next lender. And if the house is sold, you must write a payoff letter, says Gjeldum.
Less Attractive Options
If your child can’t qualify for a mortgage on her own, you could apply jointly for it, as a non-occupant co-borrower. (Cosigning is also an option, although in that case you’d have liability for the mortgage but no interest in the property.) With a Fannie- or Freddie-backed mortgage, you and your child combined must put down at least 20%; if you put down less, your child must ante up the first 5% from her own funds. Failing that, the property may qualify as an investment property, in which case you will pay a higher interest rate and you’ll be required to have more financial reserves. If you can’t come up with a total down payment of 20%, your best choice is probably an FHA loan with 3.5% down, which will factor in the income of any co-borrower who is related.
However, says Meyer, co-borrowing is a bad idea because you really aren’t in control. If your child fails to pay the mortgage, property taxes or insurance on time, that could ding your credit history or result in a lien against the property. “I try to tell my clients that if the kids can’t afford the house and the lender won’t lend, that’s telling you something,” she says. Meyer recommends that you let your kid live at home for a year and save money until she can afford to buy.
Plan Ahead
The best time to commit to helping your child and to provide the money is before your child makes a purchase offer, says Dana Hollish Hill, an exclusive buyer’s agent in Bethesda, Md. He can add that amount to the financial information sheet he will attach to his purchase offer, which will reassure sellers that he can close the deal. It could help him win the day in a bidding war.
Still, Hollish Hill finds that parents often balk at forking over the money too soon, for a number of reasons. They don’t want it sitting around in their child’s savings account, or they want to know what he is buying first, or they believe they should be involved in the process in proportion to their contribution. That’s why, says Hollish Hill, it’s important to have a frank discussion up front to answer such questions as, Whose house is it? Who’s making the purchase decision? Who has veto power?
To avoid dismay late in the game, Hollish Hill suggests that parents visit the property before the preclosing home inspection. Pretend you’re on an HGTV show: Look at three houses—the great one, the horrible one and one in-between—to gain perspective on your child’s choice, especially if he lives in a high-cost area. Dan Mazzarini’s parents didn’t see his place until a year after he bought and renovated it. Fortunately, they loved it, although he says he doesn’t think his dad understands how people live in such a tiny space. “I told him, ‘Think of it as a really nice hotel room.’ ”
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Raid Your Retirement Accounts?
You and your spouse can each withdraw up to $10,000 from a traditional IRA penalty-free to help a child buy or build a first home. (To qualify as a first-time home buyer, he or she cannot have owned a home for the past two years.) You’ll owe taxes on the withdrawal.
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You can withdraw Roth IRA contributions tax- and penalty-free at any time for any reason. You can also withdraw up to $10,000 in earnings to help kids or grandkids buy their first home without paying a 10% early-withdrawal penalty. If you’ve had the account for five years, the earnings will be tax-free, too. For details, see IRS Publication 590, Individual Retirement Arrangements.
The rules are different for 401(k) accounts. You can usually borrow as much as half of your balance, up to a maximum of $50,000, without taxes or penalties. The interest you pay on the loan goes back into your account. Loans from 401(k)s usually must be paid back within five years, but check with your employer to see if it will extend the repayment period to, say, 15 years. However, you will have just 60 or 90 days to repay the loan if you leave or lose your job. If you don’t, you’ll have to pay taxes on the unpaid balance. If you are under 55, you will also be subject to a 10% penalty.
Know the Basics
First-time home buyers must produce a down payment of at least 3% to 5% to get a conforming loan of up to $417,000 backed by Fannie Mae or Freddie Mac with a fixed interest rate. To nab an adjustable-rate mortgage or a “conforming jumbo” mortgage of up to $625,500, the down payment must be at least 10%. But if you can help your child swing 20% down, he can avoid having to pay for private mortgage insurance. An FHA loan requires just 3.5% down, but the cost of FHA insurance (an up-front fee plus an annual fee) could make a Fannie- or Freddie-backed product a better deal.
Fannie and Freddie generally prefer a maximum debt-to-income ratio (total monthly debt repayment divided by monthly pretax income) of 36%. But with compensating factors such as a high down payment, a high credit score or the potential for increased income, they may go as high as 45%. FHA generally sets the limit at 43%. Lenders will factor in your child’s student loans, even if they are deferred or in forbearance. In that case, the lender must include the anticipated monthly payment amount or assume a small percentage of the outstanding balance (Freddie Mac requires 2%, Fannie 1%) as the monthly payment. On an FHA loan, if deferment will end and repayment begin within a year of closing, the lender must include the anticipated amount.
The national average cost to close on a $200,000 mortgage in 2014 was about $2,540, according to Bankrate.com. (To see what average closing costs are in your child’s state, visit www.bankrate.com/finance/mortgages/closing-costs/united-states.aspx.) Depending on the borrower’s credit score, debt-to-income ratio and down payment, mortgage lenders may require savings (reserves) equivalent to two months’ worth of mortgage payments (see It’s Easier to Get a Mortgage in 2015).