How To Buy Your Parent’s Home
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Buying your first home can be a stressful and expensive experience. You need to decide on the right property, save for a down payment and closing costs, negotiate an offer and hope the inspection doesn’t uncover anything that makes you want to back out of the deal.
With so many unknowns, you might consider buying a home whose history you’re well acquainted with — your parent’s. While it’s true there can be benefits to buying a home from your parents or another family member, the process is not without its potential pitfalls.
We’ll cover benefits, obstacles you might face and the steps it takes to buy a home from a relative.
Mixing family and finances: Three things to watch for
Any time you mix finances and family, something can go wrong. Transactions between family members often go awry because their expectations were higher than they would be for a stranger purchasing the property.
It’s important to have clear expectations, and then put them in writing when you prepare the mortgage documents.
You can do this in two ways. The simplest is with a purchase contract, similar in format to what realtors use in the area you live. You can also request that the title company provide “escrow instructions,” which are similar to a purchase contract prepared in a for sale by owner where a realtor is not involved. In either case, you’ll need to make sure you both understand what each line of the agreement means, and set a reasonable closing date.
Even with those safeguards, there are plenty of sticking points to watch for.
Settling on a purchase price may be one of the most complicated aspects of buying a home from a family member. The child buying a home typically wants a deal. And since they’re family, they think a deal should be cut for them. In other words, they want to buy the home at a lower cost than it would sell for on the open market.
On the other hand, your parents may be selling the home because they need money for retirement. Having an open discussion about what each of you hope to accomplish with the sale price can avoid confusion and misunderstandings down the road.
Avoiding the cost of a real estate agent may be one of the benefits of buying a home from your parents, but it can also mean missing out on the advice and representation of a seasoned professional. Many times, family members don’t use a real estate agent, so they aren’t using the proper paperwork, don’t know the legal implications when things go wrong and aren’t being represented correctly.
You should also discuss the condition of the property, and who is going to be responsible for what after the house is sold. Some parents wind up fixing things for life for their children who bought the property just to avoid bad blood between family members.
How to negotiate a price on your parent’s home
When you work with a real estate agent to sell a home on the open market, the agent will recommend a sales price based on a Comparative Market Analysis, or “comps.” The comps are based on homes in the neighborhood with similar size and features that are currently for sale or sold recently.
The selling price the realtor recommends is just an estimate. The actual value of the home is what a buyer will pay for it. In a hot housing market, homes may routinely sell above asking price. In a down market, the seller may have to drop their asking price several times to sell the property.
If you’re not working with a real estate agent, you may be able to come up with your own comps using online tools.
But before going any further, it’s also a good idea to get an inspection of the house to give you a better understanding of its condition. Even if your parents’ home has been well maintained, there may be underlying structural or system issues that they are not aware of.
A thorough inspection can bring these issues to your attention, and you may be able to negotiate a lower price if the home needs significant repairs.
Once you’ve determined an estimated value, your parents can give you a discount based on the reduced commissions and other closing costs they’ll save by selling to a family member, if they want to.
How gifts of equity work when buying a parent’s home
In many cases, a parent will choose to give a gift of equity to their child when he or she is purchasing the home. No cash actually exchanges hands — the seller is simply gifting a dollar amount of the equity toward your down payment.
This is not quite the same as lowering the sales price, but it functions similarly. Lower sales prices and gifts of equity also often work in conjunction. Here’s how it works.
Let’s say a mother who recently lost her husband has a home that is worth $150,000 if she were to sell it at market value. The house has no loans on it, but it is too much for her to take care of herself, and she decides to sell it to her son. The son can only afford a loan amount of $100,000 under FHA guidelines, and has no money saved up to put down.
The mother could agree to sell the house to her son for $103,700, and then gift him 3.5% of the equity to meet his down payment requirement. The mother writes a letter gifting him the $3,629.50 minimum down payment as a “gift of equity.”
The mother nets $100,000 from her son’s new FHA mortgage, and she has the peace of mind that the home is going to a family member, and she is helping her son become a homeowner.
The rules for gifts of equity
Different loan programs handle gifts of equity differently. The differences typically come down to the maximum gift amount, and whether the borrower is required to have any skin in the game.
FHA mortgage gift rules
FHA loans are a popular mortgage choice for homebuyers because of the flexibility they provide for lower credit scores, gifted down payments and the ability to get approval with more debt compared to your income (known as debt-to-income ratio or DTI) than conventional loan programs.
When you buy a home from a family member, it is considered a “non-arm’s length” transaction. The concept of “arm’s length” is to ensure that both parties in the deal are acting in their own self interest without pressure from the other party.
FHA loans allow for a gift equity of the minimum down payment (3.5%) as long as one of the following conditions are met:
- The home was owned by the family member as a principal residence
- The family member purchasing the home occupied the property as a primary residence as a tenant, and can prove they paid rent for six month, as well as provide a copy of a lease
If these conditions can’t be met, then the minimum gift of equity will need to be 15%, and a proper gift letter will need to be provided. The language of the gift letter should clearly indicate that the equity is gifted and there are no expectations of repayment.
Conventional mortgage gift rules
Fannie Mae and Freddie Mac are government sponsored enterprises (GSEs) that purchase mortgages for residential homes. Lenders can provide conventional financing with down payments as low as 3%.
Conventional loans have more stringent credit score and DTI requirements, but they provide a lower potential down payment than conventional mortgages do. Fannie Mae has slightly different requirements than Freddie Mac when it comes to family-to-family purchases.
Fannie Mae gift of equity requirements. Fannie Mae allows gifts of equity to cover the full down payment on a home, provided the borrower meets the other requirements. You are not required to contribute your own money, but you will need a gift letter from the family member confirming no repayment is expected, and the gift of equity is a true gift.
Freddie Mac gift of equity requirements. Freddie Mac allows for a gift of equity from a family member to cover the full down payment without any cash from you as the buyer. However, in the relatively uncommon case that you are buying a second home and the gift of equity is less than 20%, then you will have to show that you have at least 5% of purchase price available from your own money. You don’t actually have to use the funds, but you will have to show that you were able to save them up from your own resources.
Potential tax consequences to your family member
Keep in mind that both the cash gift and gift of equity are subject to gift tax rules. For 2019, the annual gift tax exclusion is $15,000 (or $30,000 for a married couple). If their total gift exceeded those amounts, your parents or family member must file a gift tax return, Form 709, and should also talk to their tax adviser about any tax consequences of the gift and sale.
Buying a distressed home from a family member
Sometimes a child or parent may consider buying a home because of a pending foreclosure or because payments have become delinquent. In this case, lenders may require additional documentation, or a higher gift of equity.
If you are purchasing a house from a family member who has a current mortgage, they will likely have to provide a mortgage statement confirming the payments are current. If they aren’t, there may be additional documentation you’ll need to provide to verify that you are in fact purchasing the property to live in as your primary residence, and aren’t just buying it to bail a family member out of a bad financial situation.
Benefits of buying your parents’ house
If you love your parent’s home and they’re interested in selling, buying their home could be a win-win. Here are some potential benefits.
No or low down payment
One of the biggest benefits of buying a home from your parents or a relative: You may be able to purchase the home with a gift of equity. Equity is the difference between the loan balance and the value of a home; relatives are allowed to gift that equity, so you effectively don’t have to make a down payment.
Unlike a standard down payment, no cash actually exchanges hands. If your parent’s home is worth $100,000, and they want to gift you $20,000 of equity for a down payment, then you just need to get a loan for the remaining $80,000.
Aging parents may be getting ready to move into assisted living facilities, or maybe you’ll be moving into the house to take care of them — either way, this type of purchase usually involves a relative or parent that wants to keep the property in the family.
Lower closing costs
Whether your parents help you out with closing costs or you cover them with your own savings, you may be able to reduce the closing costs significantly. There’s no need for a real estate agent to be involved and collect a commission in a sale between parents and their children. That can save your family member around 5% of the sales price in a typical transaction.
If you’ll be financing the purchase with a mortgage, you’ll at least need lender’s title insurance. You should also negotiate to have your parents pay for an owner’s title policy, which is standard in a purchase transaction.
Even though it’s a family-to-family transaction, it’s a good idea to know if you’ll be inheriting any title issues, like judgements or liens. One of the best ways to know this is to have your purchase handled by a title company and an escrow officer or attorney if applicable to the state you live.
Real estate transactions between strangers are often difficult to coordinate from a timing perspective. If you were renting and your lease is coming to an end, you may need to find a new place to live by a specific date. Your parents may be willing to sell their home but need extra time to find a new place to live.
When buying a house from parents, you can work together to time the closing and moving dates. You can buy the home and live there together, buy it and rent it back to your parents until they’re ready to move or work out other arrangements in a way that meets both of your needs.
That flexibility is tougher to get when dealing with an unrelated party.
Obstacles you may face
Buying a home from your parents can mean significant savings, but it’s not without complication.
Qualifying for the mortgage
Whether you buy from your parents or a perfect stranger, you’ll need to qualify for a mortgage to finance your purchase. While requirements vary by lender, they typically include:
- Credit score. Most lenders require a minimum FICO score of 620.
- Debt-to-income (DTI) ratio. This number refers to what percentage of your monthly income goes to debt. Conventional lenders typically require DTI to be 36% or lower, although they may approve a DTI up to 45% if you have a high credit score and at least two months of reserves.
- Income. Lenders prefer to work with borrowers who have a stable and reliable income. They’ll review your pay stubs, W-2s, income tax returns and other documentation to make an assessment.
- Down payment. Even if your parents gift equity for a down payment, you may have to pay private mortgage insurance (PMI) if your down payment is less than 20%.
Steps to buying your parents’ house
With the pros and cons in mind, here’s a step-by-step guide to buying your parents’ home.
Step 1: Get pre-approved for a mortgage
Speaking to a lender about getting preapproved for a mortgage is a good first step. The lender can help structure the deal based on the best loan type for the child. For example, if you’re using an FHA loan, the parents can do a gift of equity for the 3.5% down payment and write in the contract for the seller to pay the closing costs.
Keep in mind the FHA guidelines outlined above. If the property has not been a primary residence for the family member you are buying from, or you can’t prove you’ve been renting the property the past six months, then the minimum gift of equity will need to be 15% for an FHA loan.
Step 2: Decide on a purchase price
Using the online resources mentioned above, get an idea of how much the home is worth. Using that information and an estimate of closing costs from your lender, decide on the purchase price and whether your parents will gift equity, pay closing costs, etc.
Step 3: Get professional advice
Buying a home from your parents can have financial, legal and tax consequences. Talk to your family attorney, financial adviser and tax accountant about your situation to make sure you understand the implications before you sign.
They may be able to help you structure the deal in ways you wouldn’t think of on your own. This may include having the family member act like a bank, and provide you with financing on the home at agreed upon monthly payments for a specified time.
A note is usually recorded and a lien is placed on the property that must be paid off in the event you decide to sell the house. This is also called a “seller-carryback,” and may be an option to avoid mortgage financing, or if you are unable to qualify for a mortgage right now.
Step 4: Fill out a sales contract
Your sale contract or purchase agreement will outline the agreed-upon price and terms for the purchase. Talk to your lender or attorney to get your state’s applicable form, or you may be able to find a template through your state’s Real Estate Commission. Both the parents and child must sign the contract.
Make sure you clearly define who is paying what. It’s important to understand that this signed contract is a legally binding contract, and any disputes can be litigated in a court of law, even if they are between family members.
You can’t just add things in after because someone forgot to bring it up when the original contract was written. Any changes to the contract will have to be agreed upon by both parties, and if there’s no agreement, then the contract can be canceled.
Make sure you decide who is paying things like property taxes, transfer taxes, closing costs, title fees and loan closing costs so there is no haggling over the last minute over things that you didn’t work out when you made your initial offer. Be sure you also decide about personal property, fixtures, and other items that will stay with the property or go with the seller.
Step 5: Officially apply for a mortgage
Talk to your lender to start the official mortgage application process. You’ll complete an application, and the lender will likely require an appraisal.
If the appraisal comes back for less than the purchase price, you may need to renegotiate a lower sales price, or you’ll need to be willing to pay the difference over the sales price. Otherwise, you may have trouble getting a mortgage on the property.
You’ll also receive an initial loan estimate that outlines the details of the down payment and provides an initial accounting of who is paying what fees. You’ll want to make sure you notify the loan officer and escrow officer or attorney if you see anything that might be incorrect.
Step 6: Complete the underwriting process
The lender will go through the process of confirming that your loan application checks out. They’ll review documentation such as W-2s, pay stubs and bank statements, make sure the appraisal reflects that the property is in good condition, and verify that the title can be transferred to you without any claims against the family member you are buying from.
You may have to provide additional documentation and answer questions, including a motivation letter from the seller explaining why they’re selling, especially if the agreed upon price is significantly below the market value. Once the underwriter has given you final loan approval and cleared your loan to close, the lender will schedule your closing date and provide a Closing Disclosure.
Step 7: Close the deal
The lender may send a notary to your home or office, or schedule closing at their office or at the title company. Before you sign, take a close look at the closing documents to make sure that the sales price, interest rate, monthly payment and other terms match the purchase contract and are reasonably close to the loan estimate you received at the beginning of the loan process.
After you sign, the paperwork will be filed, the deed will transfer property ownership to you and you’ll receive the keys to your new home.
The bottom line
Buying a home from your parents can benefit both the parents and their child — but it’s still a legal transaction. Make sure the house is a place you really want to own, and that you’re not just buying it to help your parents out of a financial bind or for nostalgia’s sake.
Finally, make sure you put everything in writing. This may help protect you from a legal perspective and help prevent disagreements down the road.