Tapping from the Bank of Mom and Dad to buy a house isn’t something most people are willing to speak about openly in North America, but Greg Gordon argues is can be a thing of beauty.
In fact, he mostly did it for mom’s sake, he said.
Gordon isn’t your typical cash-strapped millennial. The McLean, Virginia-based retired journalist and his wife have been taking out family loans since 1991. That’s when Gordon’s father died, leaving his mom, then 64, with only the family home and a modest amount of savings.
Gordon worried that the funds wouldn’t be enough. He was also concerned that all the money his father had left behind were invested in the stock market, exposing his mom to the ups and downs of the market.
To solve both problems, he decided he’s be the one providing her with some steady, low-risk retirement income — by turning her into a mortgage lender.
Early on, Gordon and his wife used one loan to finance the construction of a larger home they eventually upsized to. But they have also been turning to mom to bankroll several real estate investments, as they turned to renovating old homes in the area for additional income.
In the early 1990s, when interest rates were hovering around nine per cent, mom would get a slightly lower rate than what the banks would offer on a mortgage, Gordon said. Later on, as the general level of interest rates declined, he started paying above-market rates.
“It’s a win-win,” Gordon said.
So-called family home loans are relatively common in the U.S., but a Canadian version of that is also becoming more popular in some of Canada’s priciest markets.
One option for parents and grandparents who want to help their progeny into Vancouver’s uber-expensive real estate is to set up a second mortgage, said Chris Catliff, president and CEO of BlueShore Financial, a B.C.-based credit union.
“We see this a lot,” Catliff said via email.
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The pros and cons of a mom-and-pop second mortgage
The idea is the bank of mom and dad is lending a part of the down payment instead of just cutting a cheque. A real estate lawyer can set up the loan as a second mortgage, which is in addition to a plain-vanilla first mortgage. While the bank would be paid first as the home is liquidated, mom and dad also have a claim to the property.
Family second mortgages come with a number of pros and cons.
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It can be a loan — or a gift
On the plus side, parents can use this setup both as a proper loan and as a gift of money that has a better chance of staying in the family even after a breakup or divorce.
“Second mortgages give parents more control. It secures their money in case they may actually need it, and it also ensures that someone else, such as a child’s significant other, isn’t entitled to half the funds,” Catliff said.
Gifting all or part of the down payment exposes parents to the risk that 50 per cent of the money will go to a former spouse or partner after a breakup or divorce.
A second mortgage can be set up so that the funds would stay in the family, Catliff said.
Don’t expect to be able to ask for regular payments
Parents who’d like to lend rather than gift, though, may have to give up on the idea of receiving regular payments.
As with car and student loans, those payments would add to the children’s debt load, which might work against them in an application for a first mortgage. Banks and credit unions require borrowers to be within a certain debt-to-income ratio to reduce the chance of defaults. If payments to the second mortgage push the children above that threshold, mainstream lenders will not lend. And that vetting has become stricter at federally-regulated lenders like the big banks, which have to adhere by Otttawa’s mortgage stress test rules.
The alternative is to opt for a balloon payment that will come due when the first mortgage is paid off or when the home is sold, which doesn’t affect the children’s cash flow.
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Still, many mainstream lenders do not allow borrowers to set up a second mortgage, said Bob Aaron, a Toronto-based real estate lawyer.
That may leave first-time homebuyers with a “much smaller selection of lenders” to choose from, said Rob McLister, founder of rates-comparisons site RateSpy.com and mortgage editor at Rates.ca.
“You have less choice and less chance of getting a really competitive rate,” he said.
Both McLister and Aaron said family second mortgages are rare in Ontario.
Some families work around the rules by setting up a first mortgage and then adding a second mortgage later on working with a different real estate lawyer, both Aaron and McLister said. Needless to say, both strongly advised against it.
Catliff said BlueShore and two other large credit unions in B.C. will allow a family second mortgage if there are no regular payments or if overall debt remains within their required ratios.
What if the housing market tanks?
If the real estate market behaves as it has in Vancouver and Toronto for much of the past decade, the Bank of Mom and Dad would profit handsomely from a second mortgage that provides for a single payment upon sale of the home.
On the other hand, “if home prices plummet then the parents might be out of luck,” McLister said.
That’s because the lender with the first mortgage gets paid first and there may not be enough equity to cover any or all of the second mortgage.
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Second mortgage or prenup?
If the point is to ensure that the money stays in the family, a pre-nuptial agreement is another possibility. Before handing over the money, the boyfriend or girlfriend signs an agreement stating that her future in-laws’ donation will be excluded from the division of assets should the marriage break down.
Prenups, though, are generally “more difficult to discuss and get done than a second mortgage,” Catliff said.
Still, that conversation might be less awkward if the request for a pre-marital agreement comes from the prospective in-laws rather than the future bride or groom, said Romana King, director of content at Zolo, an online real estate marketplace.
“You can play the big, bad in-laws and then smooth over the relationship,” she said. “Or you could just say, ‘you know, we’ve come to learn that it’s best to talk about this stuff up front.'”
Yet another option is to draw up a forgivable loan agreement with interest and a balloon payment due upon sale of the home, McLister said.
“It can be simpler than a second mortgage, albeit less secure,” he added.
The bottom line, King said, is the Bank of Mom and Dad has no legal ground to stand on if it gifts or lends money without a written document somewhere detailing the conditions under which the funds were given. And even that, she added, doesn’t eliminate the risk of court battles.
That hasn’t been the case with Gordon, though.
“It worked out beautifully,” he said. “My mother is now … a millionaire.”