As the mortgage market melted down this summer and the credit markets grew chaotic, Michael McCandless, a Lexington, Mass., software developer, watched with detached curiosity. Unlike most buyers scheduled to close on new homes in mid-August, he knew his lender would come through as agreed.
The reason? The McCandlesses were financing the purchase of their dream home with a jumbo mortgage underwritten by a generous sister-in-law.
Borrowing money from one’s own inner circle is neither new nor uncommon. But it can harbor the kind of mismatched expectations that impact the Thanksgiving dinner guest list for years to come if done with too much informality.
"Typically, it is a case of ‘Here’s $25,000 to open your new business, just pay me back in three years.’ This is a recipe for disaster," says Asheesh Advani, CEO and founder of Waltham, Mass.-based CircleLending, which facilitates private loans. "Even if the business is doing fine in three years, it is unlikely the borrower will be able to make a lump sum payment to repay the loan." There is also the risk that after three years, the borrower will mistakenly remember the loan as being a gift.
Advani says that roughly 9 percent of all households have a friend/family loan outstanding. And while the $89 billion person-to-person loan market may be a drop in a consumer loan market bucket worth trillions, he decided it was enough to base a business on.
“All our products are designed to keep money in the family [or extended family when it comes to friends] instead of giving it away to a bank. Currently, we have $200 million in loans outstanding,” he adds.
CircleLending does no actual lending. It facilitates person-to-person loans for a fixed fee, managing the process, documentation and payments. It will even file reports with credit bureaus to help the borrower establish a good credit rating if the parties request it.
The loans it handles range from easily documented "handshake" loans of several hundred dollars to complicated reverse mortgages of hundreds of thousands of dollars designed to keep an ailing loved one in their home and the home in the family. The fees range accordingly from $99 to $2,500.
Among these loans is the McCandless’ mortgage.
"My sister-in-law had friends who helped relatives buy homes. But they bought the home and then rented it back to the family members. We wanted to build equity in our home," explains McCandless. CircleLending helped him structure the 30-year fixed rate private mortgage to preserve the tax-deductibility of the interest he now pays and provide a fair return — not to mention the eventual return of principal — to his sister-in-law.
"It was all very simple. We actually knew what we were signing at the closing, unlike the closing on our first house, which we financed with a traditional bank loan," he adds. He says the arrangement also keeps the personal financing out of the personal relationship.
For his sister-in-law the loan is just another fixed-income investment in her portfolio. The McCandlesses' payments are automatically deducted from their checking account and they have the flexibility to refinance if rates decline.
And though they do not anticipate it, they also have some leeway should something unforeseen happen and cause them to skip several payments.
"We empower the private lender to have all the rights a bank does, including foreclosure. But they also have the option to gift a portion of the amount outstanding or restructure the loan if they choose," says Advani, referring to the lenders as "patient capital."
"Bank loans are not flexible. If a borrower loses a job or has medical expenses — a factor in many bankruptcy filings — banks do not have the flexibility to let the borrower skip a few payments," he adds. However, private loans can be readjusted after a crisis passes to get payments back on track. "It avoids risking the principal and the relationship," says Advani.
While going through CircleLending makes it a lot easier to ask Nana to raid her retirement account to fund a college loan, or Uncle Roy for seed money to start a new business, private loans can also be arranged without a third party.
The key to doing so successfully is to keep the arrangement formal and stick to it, says Jonathan Bergman, a certified financial planner and vice president with Palisades Hudson Financial Group in Scarsdale, N.Y.
“For family relationships you want these loans to be as legitimate as possible and formalized. You want documentation. It is also a case of expectation management. The child may hope Mom and Dad will forget about the loan, but Mom and Dad may deem such gifting as inappropriate to their value system," says Bergman. He also points out that as people are growing more concerned about having enough money to last through their retirement years, they are inclined to do more lending than outright gifting of money to their children.
But while structuring and documenting loans is good policy, the IRS also requires it. If the loan terms are too lenient or the interest rates too low, the amounts involved could be deemed a gift; and if the amounts exceed the annual thresholds (currently $12,000 per person) it could trigger gift tax.
For those whose family and friends are in worse financial shape than they are, there is another source of financing that has cropped up, eBay-style. Prosper.com, also allows borrowers to go bankless.
But here the borrower is taking money from strangers participating in an auction and the lenders are taking a leap of faith on getting their money back — with no Thanksgiving invitations to hold over anyone’s head. Given that this twist is more about profit and risk than relationships, the interest rates agreed upon are likely to be higher and the flexibility significantly less forgiving than with one’s extended family.
That is because blood is typically viewed as thicker than water, and when it comes to financing, it may also be deemed more creditworthy.
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