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Is lending to your child worth the risk?

As more young people struggle to qualify for mortgages despite record-low mortgage rates and affordable home prices, some parents have decided to step in and become their child's mortgage lender.

According to Walter Molony, a spokesman for the National Association of Realtors, "26 percent of first-time homebuyers received a gift from a relative and 7 percent borrowed money from a relative."

While there are a host of risks involved in lending to family members, let alone your child, the experts say that if you cover all your bases just as any professional mortgage lender would, the deal can be a win-win for both the parent and child alike.

Business as usual

If you're going to become your child's mortgage lender, you should treat the arrangement first and foremost as a business deal. Mari Adam, president of Adam Financial Associates in Boca Raton, Fla., said with so much risk involved, you shouldn't agree to anything on a handshake.

"Unless this is a gift, you need to treat your child like you would any other borrower," says Adam. "You need to go through all the formalities and treat it as a business deal."

Act like a mortgage lender

Before you agree to finance your child's home, you need to honestly evaluate their credit to determine if they're even capable of paying you back. Pull all three credit reports and check their FICO scores. These days, banks typically require credit scores of at least 760 to qualify borrowers for the best mortgage rates, but Rick Kahler, president of Kahler Financial Group in Rapid City, S.D., said some parents may be willing to be a little more lenient than a bank otherwise would.

Pulling your child's credit reports will also provide you with a clear picture of their repayment history as well as any other "dings" over the last few years.

Even if your child's credit report has suffered from a one-time event in their life, such as a bout of unemployment or just because your child doesn't have a long enough repayment history, "You still have to seriously ask yourself if you can take the risk and if they're going to pay on time," says Kahler.

It's all about structure

Given how low interest rates are these days on investment products like CDs and bonds, even lending money to your child at below-market interest rates for a mortgage or home equity loan could prove to be a fruitful investment.

"You might be able to earn a better return than you would in CDs and your child might get a lower rate than they would at a bank," says Adam.

Unlike a bank, you'll have total flexibility in structuring the mortgage however you choose. As the lender, you have the freedom to select any interest rate for any term. Even in professional mortgage lending, more and more banks are offering nontraditional terms, such as 10, 25 or even 40-year mortgages. If you're unsure what interest rate to lend at, Kahler suggests tying the interest rate to a certain percentage over Treasury yields. This strategy would ensure you're always making a better return than you would otherwise in Treasury bills or CDs.

"The options are limitless. You can be as creative as you want," says Kahler.

Some of the same rules should still apply

Even though being your child's mortgage lender allows you to be flexible and at times forgiving, many of the same industry rules should still apply. You'll still want to require some sort of down payment, preferably 5 percent to 10 percent. As a parental lender, you will not be able to obtain private mortgage insurance (which protects the lender in case of default) as it is only available to institutional lenders.

Mike Anderson, president of Essential Mortgage in New Orleans, La., says your next step should be to get an appraisal and inspection of the property. Then visit with a real estate attorney who will draft the official mortgage paperwork and put you in touch with a title insurance company.

"You want to make sure the title of the home is clear and it's worth what they're paying for," says Anderson. "You want everything done legally with the clerk of court for everyone's protection."

"You also want to ensure you are listed as the lender on the homeowner's insurance policy and obtain a declaration sheet to ensure coverage is adequate," says Kahler. Finally, enlist the services of an escrow agent, which can cost as little as $10 per month according to Kahler, to handle payments of insurance premiums and property taxes.

Will you foreclose on your child?

Adam says you'll also have to think hard about how you'll handle late payments. What would you do if your child lost their job, were injured in an accident and couldn't keep up with their bills?

"You have to ask yourself what you would do in that situation. Will you then gift it? Will you lower the interest rate? If you're not prepared to deal with this then you shouldn't make the loan." says Adam.

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