The risk of borrowing money from your parents

Richard Montgomery for the Patriot Ledger writes: Reader question: Hello, Monty, I purchased my home in the summer of 2007 for $400,000. My folks took out a home equity loan for $80,0000, which reduced my interest rate. I am now regretting that decision. I need to sell my home, and I am not sure I will recuperate enough cash to pay off my parents' loan. If I were the only borrower involved, I would have gladly done a short sale. The idea of having poured in half a million without denting the principal is heart breaking to me. I'm a single woman and put all of my money into the interest for the last six years. How would you proceed? Thanks so much. Martha W.

Monty's answer: Hello, Martha, thanks for your question. My father once told me that money is easy to borrow, but hard to pay back.

Let us clarify a couple of points in your question. The only borrower involved with your loan is you. The money from your parents was a personal loan. They are not directly involved with your property or your mortgage; their involvement is with you as an individual. Had they asked you to sign a promissory note, you may view their loan differently.

Also, you have not “poured in half a million” into the house. Much of the value can be recovered when it sells. Assuming you invested $20,000 along with your parents, at 6% interest only on $300,000 for six years with 30 years amortization, about $108,000 went toward interest. Your income tax deduction for mortgage interest created tax savings each year. The situation you envision may not be as challenging as the one you are experiencing.

Diffusing the situation

It is not clear what has precipitated your concerns. Is the income you earned to qualify for the loan still flowing? If so, your situation is extremely different from the sale being forced on you due to losing your income. In either scenario, here are the initial steps to take:

Step 1. Develop a “short list” of real estate agents who work in your neighborhood. There is an article entitled “Choosing your real estate agent” at DearMonty.com that describes how to go about this task in such a way that greatly increases your chances of picking the right agent for you and your circumstances. For example, many agents avoid short sales. Some accept them but may not be qualified to handle them.

Step 2. Obtain three separate broker price opinions (BPO) of value on your home. They will all have different values. As a part of the agent selection process, agents prepare BPO’s to demonstrate their value to a potential customer. It gives them a chance to get face-to-face. It also gives you a chance to do the same with them. In your situation, I would not share any hint of your thoughts about the value of the home. Instead, make certain they understand you want to see the sold comparable data sheets they use in determining their opinion of your home's worth. Also ask for a detailed explanation of the market in your neighborhood in terms of competition, sales rate and future supply coming into the market, so you have a sense of neighborhood supply and demand. 

Step 3. Study the BPOs. Are some more thorough than others? Are the comparables truly comparable? The goal here is to understand these BPO’s as they will provide some confidence as to the true range of value of your home based on facts, not hearsay. Understanding the "range of value" or lowest likely price and the highest potential price is particularly important. You will have a much better sense about being underwater, and if so, the extent of your potential loss.

Step 4.  Go to your CPA (certified public accountant) or a credit counseling service armed with this information. A conversation and needs analysis may be an eye opener as you may be living above your means, and unwittingly involved your parents. Find out if this angle is a possibility.

Taking responsibility is the key

To proceed this far will take some of your time, but there is no easy answer. Having this information is critical to your ability to make sound decisions. I expect you have the intellectual and financial resources to create and execute a plan where you can work out of this and not disappoint your parents. This is how I recommend proceeding.