A Novel Idea for Current Income?

 

This article was originally featured in 2010, but in case you missed it, we are re-featuring it as part of our Retirement Portfolio Week.

"My father-in-law says it's his favorite income investment."

When I overheard one colleague say the above sentence to another a few months back, it definitely piqued my curiosity. With yields as low as they are, it's hard to find any investments that deliver a consistent stream of income, let alone one you could call a "favorite." Was he talking about an MLP, perhaps, or a preferred stock? Maybe PIMCO's Unconstrained Bond (PUBAX) fund?

As it turns out, my colleague wasn't talking about a conventional investment at all, but rather a private mortgage that he and his wife had secured through her retired dad. The father-in-law had purchased the home outright. So instead of making their interest and principal payments to a bank, as with a conventional mortgage, this couple wrote a check to the wife's father each month. They were able to pay an interest rate that was right in line with what a bank might have offered them, without incurring some of the fees of a bank loan. And her dad was thrilled because he was able to earn a consistent stream of income--an unheard-of payout of greater than 5%--on his money. I'm sure he also derived personal satisfaction by being able to help his daughter and son-in-law with such an important part of their financial lives. 

Private mortgages have increased in popularity during the past few years, and Virgin Money has even launched a service that, for a fee, offers individuals a formalized structure to make so-called "social loans" to friends and family members. But private loans are not necessarily confined to friends and family.

As the housing market has stumbled and financial institutions have tightened up their lending requirements, some homeowners, eager to unload their properties, have extended private mortgages to borrowers who wouldn't otherwise qualify for financing--often at a rate that's substantially higher than prevailing mortgage rates. There are also pools of private mortgages in which individuals can invest. Some of these pools promise double-digit interest rates during a short time frame and are tantamount to speculation, in my view.

In a best-case scenario, such as my colleague's private mortgage, the borrowers are creditworthy and not paying a usurious interest rate, the lender has a fair amount of money to invest and is being paid fairly for the risks he's taking, and both parties take all the steps they need to protect themselves in case a problem crops up. The loan would have to pass muster with the IRS, too, enabling the borrowers to deduct their mortgage interest on their taxes and ensuring that the lender isn't on the hook for gift tax.

But private mortgages can also be exceptionally risky and seem ill-advised for most of the population, in my view. Here are some of the key considerations to bear in mind if you're considering a private loan.

Diversification
If you're considering a private loan as an investment, the key question to ask is whether your portfolio is large and diversified enough to allow you to stake so much in a single, illiquid asset. As the lender, you'd have substantial collateral--the house--in case the borrowers were to run into financial trouble. But that could be a double-edged sword because houses aren't exactly liquid, as we've all learned during the past few years.

In a worst-case scenario, you could find yourself with no income and no ready market for your investment. That's why only those with substantial wealth spread across many different types of assets should consider adding a private loan to their portfolios. Before extending a private loan, it's also worthwhile to check with a disinterested third party such as an attorney and/or tax advisor to make sure you're thinking through all of the variables, including tax considerations. (More on these below.)

Documentation
No matter what type of private loan you're making--whether it's a full-blown mortgage or a $15,000 loan to help your adult daughter pay off her credit card bills--it's essential that you draft a proper contract. Specify that you're making a loan, not giving a gift, and spell out the repayment terms, including due dates, amounts due, and rates of interest. Proper documentation will also spell out the lender's interest in the property, providing the lender protection if the borrower dies, becomes disabled, or is otherwise unable to make payments on the loan. Software programs such as Quicken Family Lawyer can help you draft a contract. But if you're talking about very large sums of money--and I'd put most mortgages in this camp--turn to an attorney to help you draw one up.

Interest Rates
To help set the interest rate for a loan to a family member or friend, turn to the Applicable Federal Rates, updated by the IRS each month for short-, intermediate-, and long-term loans.  The IRS knows that some family members make "loans" that are really gifts--the lender has no real expectation of getting his or her money back. But if the rate on the loan is above the AFR, your loan won't be considered a gift by the IRS and therefore won't be subject to gift tax.

Taxes
If you charge interest on a loan--and you'll need to in order to keep the IRS from classifying your loan as a gift--that amount is included in your taxable income. Generally speaking, loans of less than $10,000 won't result in tax ramifications for either party. But if you're considering a loan that's above that threshold, check with an accountant to make sure you're minding your tax Ps and Qs. A tax advisor should also be able to discuss the steps the borrowers should take to deduct the private mortgage interest on their tax return.

Softer Considerations
Last but not least, if you're considering a loan to a friend or family member, be sure you're thinking through the ripple effects it could have for your relationship. Money is, of course, a legendary source of turmoil within families and among friends, and adding financial transactions into the mix only exacerbates the potential for problems.

See More Articles by Christine Benz

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