Mortgages with Mom and Dad; Is it smart to borrow from a family member? Often, yes; sometimes, no.(HOMES)

Byline: Jim Buchta; Staff Writer

With a 6 3/4 percent interest rate on his 30-year mortgage, Mitchell Weers of Rosemount thought he had a pretty decent rate. Then out of the blue, his father-in-law offered to better that bank rate by refinancing the mortgage with his own money at 4 percent. "That's the cheapest I'm ever going to get," said Weers, who now makes monthly mortgage payments to his in-laws rather than the bank. "I feel sort of like I'm producing income for him, so what the heck, I have to pay it anyway. Why not pay a family member so he can earn money on that?"

Welcome to the Mom and Dad Bank, an institution that's been around for as long as there have been mortgages, kneeling pads and double-digit interest rates. But with home prices rising and downsized baby boomers looking for ways of investing profits from the sale of the big family house, loans between family members are becoming more common. Still, mixing family and money can bring its own problems, experts warn. How do you pester a kid who doesn't pay on time? Does taking Dad's money give him more say over other parts of your life? And what about the kid who apparently can't make a payment but has plenty of money to eat out and take vacations?

Asheesh Advani runs a company called CircleLending that facilitates such arrangements. He said that the number of intra-family loans he's facilitated has increased 25 percent per quarter for the past 12 quarters and that his clients aren't just the filthy rich, old-money, Country Club set that you might expect. A growing number are the "mass affluent," people who have at least $100,000 of investable assets. "I think we're at the right place at the right time," he said.

Pending changes in bankruptcy laws that will make it more difficult for people to wipe the slate clean and later qualify for a commercial loan is likely to make intra-family lending even more popular, said John Mulligan, a real estate attorney in Minneapolis, who frequently facilitates housing-related loans between relatives.

Everyone agrees that being indebted to mom and dad or Uncle Moneybags is a situation that can be fraught with conflict.

John Boyd, a finance professor at the University of Minnesota's Carlson School of Management says intra-family lending can be as perilous as dating someone in the office. He said the best way to avoid problems is to get everything in writing and carefully and thoughtfully discuss the situation with other family members who might have a vested interest. That includes consulting with your spouse, other children and even your financial planner to find out more about the implications. Siblings who might feel entitled to the same benefits aren't the only ones to worry about. When Kris Wilson sold a south Minneapolis duplex to her stepdaughter several years ago, she financed the downpayment and held a contract for deed for a couple years while her stepdaughter finished nursing school. Then, the Internal Revenue Service came calling and did an audit. Wilson said they were probably checking to see if she was trying to escape paying capital gains tax on the sale of the investment property or if she had failed to pay a required gift tax. (Right now, the IRS annual gift limit is $22,000 per parent.)

Fortunately, Wilson hired an attorney to draw up an agreement and had an appraisal that was proof she sold the property for fair market value. At the time, mortgage interest rates were at about 8 percent - the same rate Wilson offered her stepdaughter 1/3 ilson, a mortgage lender for Summit Mortgage in Bloomington, said such intra-family loans were much more popular when interest rates were in the double digits, but are "not uncommon" today, particularly with buyers who need help to make a downpayment and to finance a second mortgage. She advises clients to hire an attorney to draw up paperwork and advise them about potential pitfalls. Weers, the Rosemount homeowner who borrowed nearly $200,000 from his father-in-law, searched the Internet for advice and found CircleLending, which was founded five years ago in Boston.

"We said, `Okay, if we do this we want to make it legal; we want him to have the same rights as a bank would over the property.'-"

Asheesh Advani, who worked for the World Bank in Washington, D.C., and had seen lots of inter-family lending in developing countries where commercial lenders are difficult to come by, said those transactions were mostly word-of-mouth deals with unusually high default rates. In large part, that's because the borrower and seller often failed to create structured payment arrangements that would keep the borrower disciplined. Following repayment schedules caused the default rate to drop by half, he said. "Once you fall behind you fall into a hole that's difficult to climb out of," he said. "We impose a discipline that keeps people on track." Advani said that for $599 the company will create a promissory note, mortgage and record that mortgage with the appropriate governmental office. The company does all the payment processing including direct deposit, a constantly updated amortization schedule and annual tax statements.

A growing number of Advani's clients are borrowers with adjustable rate mortgages who see the potential for rates to rise and want to lock in a lower rate with a loan from a relative. Lenders too are looking for safety in their investments. "There is some skepticism about annuities," Advani said. "People are searching for ways of earning 5 percent on their money and they're seeing intra-family mortgages as a way to do that."

Helena Semerjian of Lunenburg, Mass., said she felt that lending her daughter money to buy a $225,000 house was a better risk than the stock market. Semerjian said previous loans have gone unpaid, so she refused to make the loan without a rigid payment schedule and a legal agreement up front. They worked with CircleLending to draft an agreement and set up a payment schedule. Over the life of the loan she expects to earn more $50,000 in interest not including the interest she earns on the payments, which are deposited directly into a savings account. "The stock market is getting me nervous," she said. "So I said, `Let's take over the mortgage and exploit our daughter.'-"

Jim Buchta is at jbuchta@startribune.com.

The perils of intra-family lending 1. Rivalry Even if your loan is fully documented, consider whether you'd extend the same favor to siblings and others in the family. 2. Forgetfulness

Do not rely on verbal agreements. Make sure that all terms of the deal are clearly articulated in an agreement that is signed by the borrower (only the mortgage needs to be notarized). "Understand that the human memory is unreliable over long periods of time," attorney John Mulligan said.

3. Change

Over time, a borrower's circumstances are likely to change, so consider what will happen if that person gets divorced, has tax problems or runs into financial trouble. 4. Time

If your borrower falls behind on the payments and you get lazy about collecting the debt, be aware that most states have statute of limitation provisions that could legally eliminate a binding contract. 5. People A loan made to a family member today might be a loan to someone else tomorrow if a trustee, conservator, new spouse or heirs come into the picture. "When you change the cast of characters you can change the outcome," Mulligan said. "That friendly deal you made might turn unfriendly in the future if the people involved are no longer there." 6. Taxes

People tend to overlook tax implications when making loans and gifts, but it's very important to consider because gifts of any sort can become taxable events. "People should get advice about what their tax consequences might be and how that might integrate with estate planning," Mulligan said.

7. Advice

Most states have laws about who can offer legal and tax advice, so let that be your guide as you decide who will help you make decisions and draft contracts. Source: John Mulligan, Mulligan and Bjornnes in Minneapolis

Attorney's files produce cautionary tales

These examples from the files of real estate attorney John Mulligan illustrate the subtleties - and complexities - of making loans to a family member.

One case involves a man who lent his brother and sister-in-law money to buy a house with no documentation. A couple of years later, the borrowers divorced, and the wife got the house. The court allocated this particular debt to the wife, who soon sold the house and moved out of state. Because the documentation was inadequate, no provision was made to automatically pay the brother/lender out of the proceeds, and he got nothing. The case went to court.

Another involves a man who bought property from his father with the understanding that when the father died the balance of the loan on the property would be forgiven and title to the property would be conveyed to the son. The father gave a deed to the son to hold and record upon his death, but after he died the son discovered that irregularities in the deed document prevented it from being recorded at the courthouse. The other heirs sought to establish that the property remained in the father's estate to be shared among them. This case went to trial.