Many parents want to help their children with the dream of home ownership. When your children are young and just getting started financially, saving money for a down payment may feel like a tremendous burden. Here are some options for helping your child purchase their first home:
When acquiring a mortgage for a home purchase, the lowest interest rates that do not require private mortgage insurance (PMI) are available only when:
- a 20% down payment is made,
- the loan is made to the person who will be living in the home, and
- the person receiving the loan has a good credit score or someone with a good credit score co-signs the loan.
In general, we recommend you acquire a 30-year, fixed-rate mortgage when purchasing a home, even if you have more money to potentially put towards the down payment. Mortgage interest rates have been low in recent years, so it is best to take the largest loan possible at the lowest possible rate and leave the rest invested in the stock market. Liquidating investments could require realizing capital gains, which is a taxable event. Additionally, homeowners who itemize their deductions on their tax return are able to deduct mortgage interest up to $750,000, which effectively decreases the cost of the loan even further.
That being said, a 20% down payment when you are just getting started financially is a huge sum of money! On top of that, your child may have poor credit or no credit, making it even harder for their dream of home ownership to come true.
If your child does not have strong enough credit, you may be required to co-sign the loan allowing your child to qualify for the best interest rates. While this is common, you should be mindful before agreeing to it. If your child falls behind on payments, you will become personally responsible for the payments on their mortgage loan.
The easiest way to help your child with the down payment for a home purchase, is to give them an outright gift of cash. The mechanics of this is relatively easy, all that needs to happen is for you to give the gift to your child prior to closing on the home. You will also need to sign a Gift Letter, verifying the amount of the gift and that you do not expect the funds to be repaid.
In 2020, estate law allows $15,000 as the annual gift tax exclusion. If you are married, you and your spouse can give $30,000 to your child, estate tax free. If your child is also married, you and your spouse could give your child and their spouse $60,000 and be under the gift tax limit.
In many cases of first time home ownership, this will be plenty to make up of their down payment. However, if their down payment is more than what is allowed gift tax free, or if you don’t want to give the gift outright for some other reason, you could offer to provide the funds for the down payment in the form of a down payment loan.
For the lender (you), you can view this gift like a bond investment. For your child, this strategy is like saving for the down payment after the fact. The upside is that they get to be home owners for the 5-years that they are retroactively “saving.” This is a rare case where we truly view the agreement as a “win-win” for both parties.
For example, say you are hoping to help your child purchase a home for $200,000. The 20% down payment you would provide is $40,000. Your child would purchase the remaining 80% of the home by obtaining a 30-year fixed home mortgage, potentially with you co-signing the loan. When qualifying with a good credit score, interest rates are currently around 3.5% for this type of loan. Using this interest rate, your child’s monthly mortgage payment would be $718.47.
If you are choosing to give the down payment as a gift, you would simply gift the $40,000 to your child before they closed on the home and be done.
However, if you are offering your child the down payment as a loan, let’s say you extended that loan over a 5-year term. The current market rate for a 5-year loan is about 3.22%. Using this rate, your child would make monthly payments of $722.66 to you for 5 years. After those 5 years, your child would have 20% equity in the home, along with whatever they’ve paid off from their 30-year mortgage.
If you don’t like either of these options, you could also chose to provide the 20% down payment and be a partial owner of the home. Your name would be recorded on the deed of the home and when the time comes for your child to sell, you would receive 20% of the sale proceeds.
We would never recommend extending a loan to your child without proper documentation. You should always make sure that you have a contract in place which outlines all of the terms of the agreement.
While it may seem strange to draw up a contract among friends or family, explaining the reasoning behind it may help ease concerns. The contract protects not just the finances but also the relationship.
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