Best Ways to Offer Down-Payment Assistance

Consumer Reports has no financial relationship with advertisers on this site.

Consumer Reports has no financial relationship with advertisers on this site.

According to NerdWallet's 2018 Home Buyer Report, 82 percent of millennials say that buying a home is a priority. But the sales price of one in the U.S. as of March 2019 averages $376,000, according to the most recent census data (PDF). At that price, coming up with a down payment is no easy feat.

Not surprisingly, cost tops the list of concerns millennials have about homebuying, the NerdWallet report found. Student-loan debt is partly to blame, as are tight housing markets in many parts of the country. 

Nonetheless, mortgage rates are still historically low—around 4.04 percent for a 30-year fixed-rate loan, according to Bankrate. If you can afford to give your adult child help with a down payment, it could be a good time to help him or her own a home rather than renting.

Just take these considerations into account before you offer any down-payment assistance.

Check Out Low Down-Payment Options

First, make sure your relative has looked into programs that let him or her put down less than the traditional 10 to 20 percent. Fannie Mae and Freddie Mac, the quasi-governmental entities that underwrite at least half of the country’s mortgages, offer mortgages that require just 3 percent down, significantly less than the 5 percent down often required for standard mortgages.

Be aware that making a small down payment does have drawbacks. Until your relative's home equity reaches 20 percent, he or she will need to pay mortgage insurance, usually at an annual cost of 0.5 to 1 percent of the loan’s value. Payment is made monthly, which compensates the lender in the event of a default. (FHA mortgages require mortgage insurance for the duration of the loan.)

And because the buyer is putting down less, he or she will face larger monthly mortgage payments.

A large down payment can make a buyer more attractive to sellers.

Gift, but Document

Gifting is preferable to lending when offering down-payment assistance, says Bob Harkson, chief financial planner at Phase 2 Wealth Advisors in Gig Harbor, Wash. It's "cleaner" than a loan and can lead to fewer problems with mortgage lenders and the IRS, he explains.

But you'll need to document that it's really a gift. Otherwise, a lender reviewing your child's bank statements may construe a large recent deposit as a loan. A mortgage officer could take into account estimated monthly repayments for that loan when determining how big a mortgage to lend.

"Lenders are astute," Harkson says. "They watch the cash flow." The solution: Provide the lender with a signed letter stating that the money is indeed a gift.

"That's if you're going to be ethical and legal about it," Harkson adds. "I’ve seen people 'gift' money and actually require their kids pay it back. But technically, you’re not supposed to do that."

Be Aware of Other Gifting Considerations

There are also  tax consequences to gifting, though they affect few people. You can gift up to $15,000 to an unlimited number of people in 2019 without having to pay the federal gift tax of up to 40 percent.

If you're giving down-payment assistance to a couple, you may want to think about who you exactly you want to give the money to. "Not every parent is comfortable giving gifts to a child-in-law," notes Emily Sanders, a CPA and managing director of the Atlanta office of United Capital, a financial life management company. But if you are, that increases the overall amount you can give. For example, parents filing taxes jointly could each give a son and daughter-in-law $15,000. That’s $30,000 per person, or $60,000 total.

Another strategy to avoid paying tax is to make one gift of up to $15,000 in December and another one in January, says Mary Clements Pajak, a trusts and estates partner at Pierce Atwood, a law firm based in Boston. 

Use IRA Funds Sparingly

Anyone wanting to help with a down payment can withdraw $10,000 penalty-free from an IRA to fund qualified costs related to the purchase of a relative's first home. Those include closing, finance, and settlement costs.

That's $10,000 per person, which means that, in theory, a mother and father could give a daughter and son-in-law a total of $40,000 this way. (If you're older than 59½, your withdrawals—known officially as distributions—aren't subject to that 10 percent penalty regardless of how the money is used.)

IRA distributions taken out for a first-home purchase must be used within 120 days of when the money is withdrawn. And if the distribution originates from a traditional IRA, you'll have to pay ordinary income tax on it.

And a final caveat: Unless you're sure you won’t need the money, it’s better to leave it invested and growing in the IRA. Take the money from another source. "I always recommend that parents make sure they’re providing for their own retirement before they think about their kids," Harkson says. "Consider your ability to pay the tax and your overall big picture."

Know the Rules on Family Loans

In spite of their drawbacks, direct loans toward down-payment assistance can benefit both sides financially if done correctly.

If you lend your child money at, say, a 3.5 percent interest rate, you’ll get a return exceeding the estimated 2.7 to 3.1 percent that a large, diversified fixed-income fund currently yields. Your child will get an interest rate lower than the national average of around 4.57 percent that banks are now offering for 30-year fixed mortgages. 

What’s more, so-called intrafamily loans usually don’t have loan-origination fees, points, mortgage insurance, or other lender costs. And families can arrange for flexible repayment schedules.

Be sure to craft the deal carefully to avoid IRS scrutiny—and family acrimony. For any loan higher than $15,000 not to be construed as a gift, the interest rate must be at least as high as the IRS monthly Applicable Federal Rate (AFR), currently about 3 percent for long-term loans. You can find the AFR easily at National Family Mortgage, a service that helps create intrafamily loans.

Have an attorney draft a detailed promissory note and record it properly under state and local laws. That way, your child can claim a mortgage interest deduction, assuming that itemizing is still worthwhile under the new tax law. 

Keep in mind, though, that if you choose this option, you'll have to claim the interest portion of the mortgage payments you receive as income on your tax returns. 

Avoid a Family Flare-Up

Before you draft the loan paperwork, make sure all interested parties communicate fully, stresses ReKeithen Miller, a certified financial planner at the Palisades Hudson Financial Group in Atlanta. A common situation he sees is when a father discusses the loan terms with his child but fails to include the mother in the conversation. Then when the father dies, the adult child insists to the mother that the father forgave the loan before his death.

“Now mom has to decide if her child is telling the truth,” Miller warns. He suggests using caution with any such arrangements. “I generally advise clients that they probably shouldn’t loan any amount of money they can’t stand to lose." 

More from Consumer Reports:
Top pick tires for 2016
Best used cars for $25,000 and less
7 best mattresses for couples

Consumer Reports is an independent, nonprofit organization that works side by side with consumers to create a fairer, safer, and healthier world. CR does not endorse products or services, and does not accept advertising. Copyright © 2019, Consumer Reports, Inc.