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A private mortgage can let a buyer finance a home through a family member, friend, seller or other private lender instead of a traditional bank. But an informal relationship does not make the loan informal: A private mortgage should generally spell out the interest rate, repayment schedule, collateral and what happens if the borrower defaults. Tax rules, property-recording requirements and consumer lending laws may also apply depending on how the arrangement is structured. Putting those details in writing can help protect both the borrower and lender.
A financial advisor can offer valuable insight and guidance on how a private mortgage fits into a broader financial plan.
What Is a Private Mortgage?
You’re probably more familiar with the term private mortgage insurance than the concept of a private mortgage. It’s not as common as financing a home through a bank or mortgage company, but private financing can be used in transactions between family members, friends, buyers and sellers or other private parties.
A private mortgage is generally a loan secured by real estate that is funded by an individual or other private source rather than a conventional bank or institutional mortgage lender. The borrower signs a promissory note establishing the debt, while a mortgage, deed of trust or similar instrument can give the lender a security interest in the property.
Calling a loan “private” does not necessarily exempt it from mortgage, lending or consumer-protection laws. Federal and state requirements can depend on factors such as who is making the loan, whether the lender regularly extends credit and whether the arrangement involves seller financing.
Private Mortgage vs. Traditional Mortgage: What’s the Difference?
A private mortgage and a traditional mortgage can both finance a home purchase, but they differ in who provides the money and how the loan is structured and administered. A private mortgage may offer more flexibility, especially between family members or other people who know each other, while a traditional mortgage usually follows a standardized underwriting, servicing and reporting process.
| Factor | Private Mortgage | Traditional Mortgage |
|---|---|---|
| Lender | Individual, family member, seller or other private source | Bank, credit union or mortgage company |
| Underwriting | Can be negotiated between the parties, subject to applicable law | Typically based on standardized income, credit and debt requirements |
| Interest rate | Negotiated by the parties, but below-market rates can create tax consequences | Based on market rates, borrower qualifications and loan terms |
| Down payment | May be more flexible depending on the agreement | Depends on the mortgage program and lender requirements |
| Documentation | Requires a promissory note and generally a mortgage, deed of trust or other security instrument | Prepared through the lender’s standard mortgage and closing process |
| Property lien | Should generally be properly recorded or perfected under applicable law | Typically recorded as part of the closing process |
| Monthly payments | Paid directly to the lender or through a third-party servicer | Usually handled by a mortgage servicer |
| Credit reporting | May not be reported unless the lender or servicer furnishes information to credit bureaus | Typically reported to major credit bureaus |
| Taxes | Below-market interest and family-loan rules can create additional tax considerations | Standard mortgage-interest and lender-reporting rules generally apply |
| Flexibility | Terms may be customized more easily | Terms are generally more standardized |
| Default | Rights and remedies depend on the loan documents and applicable state law | Lender may pursue foreclosure under the mortgage terms and applicable law |
Neither structure is automatically better. A private mortgage may work well when the parties want more flexible terms or when a family member wants to help finance a home purchase. A traditional mortgage may offer a more standardized process, established servicing and routine credit reporting.
If you use private financing, the flexibility should not come at the expense of documentation. Treating the arrangement as a formal secured loan can help protect both the borrower and lender if financial circumstances or personal relationships change.
Tip 1: Put Everything in Writing
It’s in your best interest to formalize your mortgage loan, even if it’s an intra-family affair. The parties should generally use a written promissory note that identifies the amount borrowed, interest rate, repayment schedule, maturity date and consequences of missed payments. A mortgage, deed of trust or other applicable security instrument can then secure the debt with the property.
The mortgage is not registered with the IRS. Instead, the security instrument generally needs to be recorded or otherwise perfected according to the applicable state or local law. IRS rules for the home mortgage interest deduction specifically require a secured debt to be recorded or otherwise perfected under applicable law. An attorney can help draft and record the documents, while a certified public accountant (CPA) or other tax professional can address the tax treatment.
You want to make sure you have a valid security instrument that secures the loan. This can give the lender the right to pursue the property as collateral if the borrower defaults, subject to the agreement and applicable foreclosure and state laws. Without a properly perfected security interest, the lender may have fewer protections and the borrower may also have difficulty satisfying the secured-debt requirements for a home mortgage interest deduction.
Tip 2: Set an Interest Rate
You may think a private or family mortgage should be interest-free, but charging little or no interest can create federal tax consequences. The IRS publishes Applicable Federal Rates (AFRs) each month, and loans carrying interest below the applicable rate can be treated as below-market loans under federal tax rules. In some cases, the lender may be treated as receiving interest income even when that interest was not actually paid, while the forgone interest may also be treated as a gift or another type of transfer.
The AFR should not be confused with the requirements for the home mortgage interest deduction. A borrower’s ability to deduct interest generally depends on factors including whether they itemize deductions, whether the debt is secured by a qualified home and how the borrowed money is used. The IRS currently limits the deduction for qualifying post-Dec. 15, 2017 home acquisition debt to interest attributable to up to $750,000 of debt, or $375,000 for married taxpayers filing separately, subject to applicable rules and exceptions.
If you’re the lender of a private mortgage, the interest you receive is generally taxable interest income. Because AFRs change monthly, borrowers and lenders should check the rate applicable when structuring the loan rather than relying on an older published rate.
Tip 3: Discuss Contingencies
Before committing to a private mortgage, borrower and lender should discuss various contingencies that could complicate the lending agreement. What will happen if the borrower runs into financial trouble and misses a payment? Will there be a grace period or late fee? Can the loan be prepaid? What happens if the borrower dies, sells the home, refinances or wants to modify the payment schedule? The agreement should also address taxes, insurance and responsibility for maintaining the property when appropriate.
Changing the loan later can have legal and tax consequences, so the parties should avoid relying on an informal understanding that they will simply “work something out.” An attorney and tax professional can help structure the original agreement and evaluate proposed modifications. A third-party loan servicer may also be useful for collecting payments, maintaining records and producing statements.
Tip 4: Keep it Civil
Remember that you had a personal relationship with your lender or borrower before you had a financial relationship. If things get tense, enlist the help of a mediator before your mortgage becomes a sticking point.
If you don’t think your relationship could take the strain of financial entanglement on such a large scale, skip the family mortgage and consider a financial gift arrangement instead. You don’t want to be that family arguing over money during Thanksgiving dinner.
Tip 5: Get Credit
If you forgo a conventional mortgage in favor of a private mortgage, your payments may not automatically appear on your credit reports. Creditors generally choose whether to furnish account information to credit reporting companies, and a private individual making a family loan may not report at all.
As the borrower, you generally cannot simply send your mortgage agreement and payment records to the major credit bureaus and have the account added to your credit history. If building credit is important, ask the lender before completing the loan whether it reports payment history or whether a third-party servicing company can handle credit reporting. Even then, reporting policies can vary among credit bureaus.
Bottom Line
A private mortgage can give family members, friends or other private parties more flexibility in financing a home, but it should generally be treated as a formal loan rather than a handshake agreement. A written promissory note, properly recorded security instrument, appropriate interest rate and clear repayment terms can help protect both sides. Tax rules can also matter, particularly when a family loan charges below-market interest, while state lending and foreclosure laws may affect how the arrangement is structured and enforced. Before completing a private mortgage, consider having an attorney review the documents and a tax professional evaluate the potential federal and state tax consequences.
Advice for Home Buying
- Before making a big purchase like a house, consider talking to a financial advisor about how it will impact your financial plan and budget. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free matching tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- You may find that a private mortgage isn’t in your best interest. If things fall through, you can always go the traditional route. Interest rates are still lower than previous decades, and many banks offer a variety of term lengths.
- You can also find out how other mortgage lenders operate by reading reviews. It helps to have alternative options if things fall through with a private mortgage.
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