When you meet, give the potential lender ample time to ask questions, and don't expect a decision on the spot.

The Loan Amount and House Purchase Price

How much you'll ask for depends on how much you expect to pay for your house and how much you think your parents or other private lender can spare. Your intrafamily loan will most likely be a second mortgage, to supplement financing from a bank or other traditional lender. The terms "first" and "second" literally refer to who gets paid first if there's a foreclosure. Your bank or institutional lender will no doubt insist on being the first in line, regardless of the size of its loan.

Your house purchase price won't be exact unless you've already made an offer and had it accepted. If you're still looking, be prepared to show the potential lender a close estimate, based on the price range you're looking in. If your private lender wants to make sure the house you find will be worth what you plan to pay, offer to get it appraised prior to purchase (if you're not already doing that for an institutional lender).

The Interest Rate You Propose to Pay

For a private loan, the interest rate you and your lender pick can in theory be anything between 0% and the limit set by usury law in your state. But for practical as well as tax reasons, it's best, according to adviser Asheesh Advani, to charge a rate that's higher than the Applicable Federal Rate (or AFR; more on that below) but lower than what you'd pay to an institutional lender. Propose paying a little less than half the difference between these two. For example, if fixed rate mortgages cost 6% and the AFR is at 4%, you might propose paying 5% interest. (In this example, banks would probably be paying around 3% on CDs, but that figure becomes irrelevant given the minimum 4% AFR.) Websites such as www.compareinterestrates.com, www.bankrate.com, and www.hsh.com will give you a sense of current interest rates. By the way, although the AFR and interest rates change month by month, your loan doesn't have to follow suit-it's fine to stick with the rate you settle on in the month you sign the loan. will give you a sense of current interest rates. By the way, although the AFR and interest rates change month by month, your loan doesn't have to follow suit-it's fine to stick with the rate you settle on in the month you sign the loan.

CD-ROM.

Use the "Private Loan Terms Worksheet" in the Homebuyer's Toolkit on the CD-ROM to organize your presentation to a parent or other private leader.

TIP.

Is your family member reluctant to charge you that much? Tell them they can always decide later to "forgive" you some or all of your payments, of not only interest but principal. For tax reasons, they should write you a letter referencing the loan and stating the amount they're forgiving. They'll also have to factor this decision into their gift tax obligations-forgiven loan payments are considered gifts. And it's best not to structure the whole loan with the assumption you'll never repay-the IRS sees this as a fraudulent way of avoiding gift tax, by stretching a one-time gift out over several years. Tell them they can always decide later to "forgive" you some or all of your payments, of not only interest but principal. For tax reasons, they should write you a letter referencing the loan and stating the amount they're forgiving. They'll also have to factor this decision into their gift tax obligations-forgiven loan payments are considered gifts. And it's best not to structure the whole loan with the assumption you'll never repay-the IRS sees this as a fraudulent way of avoiding gift tax, by stretching a one-time gift out over several years.

Check the AFR: Too-Low Interest May Cause Your Lender Tax Problems The IRS sets a minimum rate for private loans, called the "Applicable Federal Rate" (AFR), each month. The exact percentage varies but is usually less than bank mortgage rates and higher than money-market account or CD rates. In late 2008, the AFR averaged a little less than 4.5% for long-term loans (those lasting longer than nine years). For the current rate, visit the "Tips & Tools" section of www.virginmoneyus.com, which updates the AFR monthly and explains how it applies to intrafamily loans. You can also search the IRS website at www.irs.gov for the latest AFR. for the latest AFR.What's the big deal if your private lender charges you less than the AFR-or even no interest at all? No problem for you (who wouldn't want a low interest rate?), but there may be tax ramifications for the lender. This is mainly an issue if you're borrowing a substantial amount of money from a relative or friend, or receiving a loan on top of a gift that exceeded the $12,000 exclusion. If the interest rate doesn't meet the AFR, the IRS will "impute" the interest to your lender-meaning it will act as though your lender really received the AFR-level interest on the loan. The question then becomes, where did the interest money go? Aha, reasons the IRS, your lender gave it right back to you, as a gift. Then the IRS can demand that the private lender file a gift tax return for any amount over the annual gift tax exclusion.Also, even if your private lender charges you less than the "imputed" interest rate, the IRS requires him or her to report interest income at the imputed rate. If the lender doesn't and is audited, and the IRS discovers the omission (unlikely), the IRS will readjust his or her income using the imputed interest rate and charge the tax owed on the readjusted income plus a penalty. Theoretically, the IRS could zap the giver under both income and gift tax rules.

Other Proposed Loan Terms

You don't need to go into your discussion with a completely drafted loan agreement-after all, part of your objective will be to negotiate those details with the lender. Still, you can show that you've thought carefully about how to structure the loan profitably for both of you, by suggesting a: * repayment schedule (such as monthly or quarterly)* mortgage term (length)* payment amount, and* plan if things go wrong, such as late payments and fees, what constitutes loan default, and loan restructuring options.

Again, be sure to run these by your institutional lender, if any, before finalizing your loan agreement with a relative or friend, to make sure you won't be undermining your qualification for institutional financing.

Gracias, Arigato, Merci Find a way to show your thanks for a gift or loan-a card, lunch at your new house, and maybe more. In case you're stuck for gift ideas, check at www.redenvelope.com. But be aware that, depending on your relationship with your relatives, they may also expect frequent stays in your new guest room, want you to follow their decorating advice, or feel that they can comment on your spending habits. Then again, some may act like this without having contributed to your house purchase!

Creating Your Loan Documents

If your relative or friend agrees to lend you money, you'll need to finalize the loan with the proper legal paperwork. A handshake isn't good enough for anyone. For one thing, it's easy to misunderstand something you've only talked about. Clarifying and writing your agreement down now avoids disputes, as well as memory lapses down the line. For another, failing to record your lender's mortgage on the property leaves that person out in the cold if some other lender or creditor forecloses on your house-they wouldn't be entitled to any of the proceeds, some of which might go to a creditor who came along later (like a contractor who worked on your house, whom you haven't yet repaid and who files a lien). And finally, written proof that you're paying mortgage interest allows you to deduct it at tax time.

To make your agreement legally binding, you'll need these two documents: * Promissory note. Promissory note. You'll need to sign a note for the amount of the loan, including the rate of interest, repayment schedule, and other terms, such as penalties for late payments. You can find several promissory notes on Nolo's website ( You'll need to sign a note for the amount of the loan, including the rate of interest, repayment schedule, and other terms, such as penalties for late payments. You can find several promissory notes on Nolo's website (www.nolo.com). If you're borrowing only a few thousand dollars or less, a promissory note may be all you need. But for most intrafamily loans, it makes legal and financial sense to also prepare a mortgage.* Mortgage (or "deed of trust," in some states). Mortgage (or "deed of trust," in some states). A mortgage gives your lender an interest in your property to secure repayment of your debt (per the promissory note). It needs to be recorded with a public authority, such as the registry of deeds. A mortgage gives your lender an interest in your property to secure repayment of your debt (per the promissory note). It needs to be recorded with a public authority, such as the registry of deeds.

Unless you're experienced in real estate transactions, we recommend you get an expert's help with preparing and recording a mortgage and related legal documents. Ask your lender or closing agent for advice, or check out Virgin Money (described below).

How Virgin Money Can Help Virgin Money is the leader in managing "person-to-person" loans between relatives, friends, and other private parties. The company provides a full range of services for managing interpersonal loans and mortgages, including loan documentation, mortgage recording, repayment management, electronic funds transfer, online accounts, year-end reports, and credit reporting. Virgin Money also offers traditional mortgages. For more information, visit www.virginmoneyus.com or call 800-805-2472. or call 800-805-2472.

A One-Person Bank: Seller Financing

An estimated 10% of home sales involve some sort of seller financing. Surprisingly, the seller can be one of the most flexible sources of financing for your new house. Seem counterintuitive? There are several ways that sellers can help-admittedly not that common, but keep your eyes open for situations where: * The seller's house has substantially appreciated in value over the years, so that the seller will owe a high amount of capital gains tax when it's sold. By in effect selling the house to you over time, the seller can reduce the tax hit.* The seller is having difficulty finding a qualified buyer or is anxious to move a house that's been on the market a long time.* The seller would prefer to be paid over time at a favorable interest rate rather than receive all the equity at the time of sale, perhaps to supply a regular income for upcoming retirement.* The seller can justify a higher price by helping with the financing.Here's a brief overview of the various forms of seller financing. As with loans from family and friends, be sure to consult with your primary lender to find out how seller financing will affect your eligibility, and get expert help for documenting and recording the mortgage.

Getting a Mortgage From the Seller

A form of seller financing often called a "seller carryback" allows the seller to essentially sell you the house on an installment plan. The seller transfers ownership of the house to you at the closing, but in return receives a promissory note entitling him or her to scheduled payments and a mortgage, providing a lien on the property until the loan is repaid. It's often structured so that the buyer has a balloon payment after a few years, at which point you'd either refinance or move out of the house. This kind of arrangement works best for a seller who already owns the house free and clear and won't have to turn around and pay off a bank loan upon sale.

You can also use seller financing to cover a second mortgage, when the amount you've saved for a down payment plus your bank loan doesn't quite add up to the sales price. Adviser Asheesh Advani says, "You could save 1% or 2% by offering to accept a seller-finance arrangement rather than taking out a second bank loan."

If seller financing looks like an option, approach the seller in an organized way (see our suggestions, above, for approaching family and friends). Be prepared to provide detailed information about your income, credit, and employment history, plus references-more information than you'd need for a close relative. As with other private loans, seller financing can be flexible and creative. You might ask the seller for: * a competitive interest rate (less than you'd pay for a fixed-rate mortgage)* low initial payments (unless you can easily afford high ones)* a mortgage rate buydown (as described below)* no prepayment penalty* no large balloon payment for at least five years, plus the right to extend the loan at a reasonable interest rate if market conditions make it impossible to refinance or pay the balloon payment in full, and* the right to have a creditworthy buyer assume the second mortgage if you sell the house.

This is a hard bargain, so be prepared to give up on the less important terms.

Assuming the Seller's Mortgage

Another option is to assume the seller's mortgage: Essentially, you take the seller's place with the seller's mortgage holder, subject to all the conditions the seller agreed to. This type of financing makes most sense when the interest rate on the seller's mortgage is lower than the current market rate. It's all aboveboard, done with the lender's consent (unlike something called a "wraparound," where you pay the seller and the seller pays the unwitting bank-not recommended).

One problem with assumable mortgages is that you'll probably have to pay much more for the property than the seller owes on his or her mortgage and will either need a very large down payment or a second mortgage to cover the difference. Since second mortgages are usually at a higher interest rate, you won't want to assume a seller's mortgage if the savings on the assumed mortgage will be cancelled out by the higher rate on the second mortgage.

Another potential problem is that usually, only adjustable rate mortgages (plus FHA and VA loans, with some conditions) are assumable, so the interest rate probably won't stay where it is. Examine how high it might go using the suggestions in Chapter 6.

Finally, the seller usually wants something out of the deal, too: often, a higher asking price. That's because the seller is still on the hook for the mortgage if you default.

CAUTION.

Seller-funded down payment assistance programs are illegal. The Housing and Economic Recovery Act of 2008 prohibits the use of down payment assistance programs funded by those who have a financial interest in the sale, such as Nehemia and AmeriDream. This new federal law does not prohibit other assistance programs provided by nonprofits funded by other sources, churches, employers, or family members. And the law does not prohibit the type of seller financing we discuss above. Check with your lender or local government housing agency if you have questions on the legality of a particular program. The Housing and Economic Recovery Act of 2008 prohibits the use of down payment assistance programs funded by those who have a financial interest in the sale, such as Nehemia and AmeriDream. This new federal law does not prohibit other assistance programs provided by nonprofits funded by other sources, churches, employers, or family members. And the law does not prohibit the type of seller financing we discuss above. Check with your lender or local government housing agency if you have questions on the legality of a particular program.

New Home Financing

If you're buying a newly constructed home, the developer is likely to offer you some unique financing alternatives. The usual possibilities include closing costs paid by the developer, mortgage subsidies (buydowns), or allowances for upgrades like higher-quality fixtures. All are more common when developers have large numbers of unsold properties and there's a large supply of new homes on the market. (And in particularly slow markets, developers may offer packages featuring everything from cruises to free fireplaces!)

Mortgage Rate Buydowns

To make its houses more affordable, a developer may offer to "buy down" your mortgage. That means subsidizing the interest rate you pay for the first two or three years by prepaying part of the mortgage interest. In a 2-1 buydown, for example, you pay a below-market interest rate (and make reduced mortgage payments) the first year of the loan, and a slightly higher (but still below-market) rate the second year, with the developer filling in the gaps. The two-year period is meant to cover the time when money is usually tightest for first-time homebuyers.

EXAMPLE:.

Depending on the particular developer, you may be able to apply a buydown to a mortgage you find yourself or you may be limited to mortgages offered through a developer's preferred lender. You usually need good credit to qualify for this type of program.

And as with any loan package, make sure the buydown works for you-will you really be able to pay the increased mortgage payments after the initial reduced-rate period? If there are any strings attached, such as high initial points or above-market interest rates after the buydown period ends, also consider how much you'll end up paying over the life of that loan. If you can afford higher monthly payments from the start, you may find a more competitive mortgage elsewhere. Use one of the mortgage calculators recommended in Chapter 6 to compare mortgage options.

Other Developer Financing Incentives

Many developers offer special financing deals to new homebuyers who use the developer's in-house or preferred lender. In some cases, the lender has done a blanket appraisal of all houses in the particular development, so you don't have to pay for a new appraisal. The lender will probably also offer special mortgage programs, often with faster or easier approval for creditworthy purchasers and simpler closing procedures. To seal the deal, developers may offer to pay closing costs or points; provide upgrades, such as better-quality carpet or countertops; even offer gift certificates for home design stores.

Although the developer may present its in-house financing as the world's greatest deal or even the only possible deal, don't cave to the pressure without doing your research. It might seem easier (time- and paper-wise) to go with the developer's recommendation, but that convenience may come at a price-namely, above-market interest rates. Particularly if the developer is anxious to sell, you might instead get a loan from another lender but negotiate with the developer for another benefit like a lower purchase price (a better deal than most financial incentives); a mortgage buydown; extra features, such as more closets or built-in bookshelves; or upgrades such as higher-quality lighting.

Backed by Uncle Sam: Government-Assisted Loans

The government thinks homeownership is a good thing-in fact, the federal Department of Housing and Urban Development (HUD) declares that its mission is "to increase homeownership, support community development, and increase access to affordable housing free from discrimination." That may translate into some financial help for you, depending on where you live and whether you meet the eligibility requirements for programs administered by the: * Federal Housing Administration (FHA)* U.S. Department of Veterans Affairs (VA), or* state and local housing finance programs.

We provide a brief overview of government low-down-payment and insured mortgage programs below, with contact information so you can check the latest offerings and eligibility requirements. New programs spring up all the time, most recently including special loan packages in HUD "revitalization" areas for teachers, firefighters, and law enforcement officers.

The application process for many government loan programs is similar to applying for a conventional loan. Your mortgage broker or lender can tell you what's available, which lenders participate, and whether or not you qualify based on your income and other eligibility requirements (such as your veteran status) and the price of the house you want to buy. Because the maximum loan amounts for these loans tend to be modest, you're most likely to benefit if you're of low to moderate income and buying in a low-priced area, and if your credit makes it difficult to qualify for a competitive rate from institutional lenders.

TIP.

All types of homes qualify. Government loans are often available for loans for new houses, condominiums, co-ops, and manufactured homes-although there will be a few more hoops to jump through in terms of inspections, warranties, and other requirements. Government loans are often available for loans for new houses, condominiums, co-ops, and manufactured homes-although there will be a few more hoops to jump through in terms of inspections, warranties, and other requirements.

CHECK IT OUT.

Looking for a list of all government housing loan programs? Check out the "Housing" and "Veteran" Loans sections at Check out the "Housing" and "Veteran" Loans sections at www.govloans.gov. In addition, be sure to see the sites mentioned below for FHA, VA, and state and local housing finance programs.

FHA Financing

The Federal Housing Administration, or FHA (an agency of HUD), helps people get into a home using a low down payment. The FHA itself doesn't provide financing, but it does provide a guaranty for a variety of fixed- and adjustable-rate mortgages. The guaranty means that if you default and the lender forecloses, the FHA covers the entire amount. This reduces the lender's risk and increases the lender's willingness to offer low-down-payment plans.

The FHA's most popular program (Section 203(b)) requires a low down payment-usually about 3.5% of the sales price (an attractive alternative to the 5%-10% down payment most lenders require). This low down payment, coupled with higher loan limits, makes FHA financing more popular with homebuyers now than in previous years. (Maximum loan limits vary by area, but are generally between $271,050 and $625,500 for single-family homes in 2009.) FHA loans are assumable by qualified buyers, which may make your house easier to sell when the time comes. Also, there is no prepayment penalty, should you decide to refinance or pay off your loan early. FHA loans are a particularly good option for buyers with less than stellar credit histories (including bankruptcy), because they're generally easier to qualify for than conventional loans.