There is a number the IRS publishes every month that settles most of the debate about lending money to your kids. It is called the applicable federal rate, or AFR, and it sets the floor for what you can charge a family member before the government starts treating part of the arrangement as a gift. Short-term loans under three years currently sit somewhere around 4%. Anything running longer than nine years, which is where a home loan lands, is closer to 5%. That single figure answers more of this question than most people expect.
The question came from parents whose son and daughter-in-law are trying to buy a first home in an expensive market. Mortgage rates are unpleasant, the parents have the cash, and they want to lend at a rate below what a bank would offer. They wanted to know how far below they can go before the IRS reclassifies the discount, and what else they should be considering.
The AFR Is a Floor, Not a Penalty
The IRS is not trying to stop you from helping your children. It simply needs a benchmark, because otherwise any transfer could be dressed up as a loan at 0.1% interest and escape gift treatment entirely. So they publish a minimum, and as long as you charge at least that, you have made a loan and nothing more.
Notice that the floor sits well below a retail mortgage. Lending at the long-term AFR is already meaningfully cheaper than what a bank will quote, and you stay comfortably inside the rules.
What Going Below the Floor Actually Costs
Suppose the AFR is not generous enough for you. You would rather lend at 2% when the applicable rate is 5%. You can do that. The IRS just quantifies the difference and calls it a gift.
Simplified, on a one million dollar loan, a three point discount is roughly $30,000 of value transferred each year. There is more nuance in how imputed interest is calculated and reported, and there are forms involved, but the principle is that straightforward. The gap between what you charged and what you should have charged gets counted as a gift, year after year, for the life of the loan. That is not automatically a problem. It is just something to choose on purpose rather than discover later.
Being the Bank Is More Work Than It Sounds
Here is what I would push back on first. If you hold the mortgage, you need to hold a real mortgage: a properly documented note, an amortization schedule tracking principal and interest, a monthly payment coming in, and a plan for property taxes and insurance. Maybe you love a well-built spreadsheet and this sounds fun. For most families it is friction, and the friction is not only administrative. It puts a lender and borrower relationship inside a parent and child relationship, permanently.
Weigh that against what you are actually buying, which in most cases is one or two percentage points of interest. Real money, and frequently smaller than what you could simply hand them.
Gifting Is Usually the Cleaner Instrument
Run the alternative. The annual gift exclusion this year is $19,000 per donor per recipient. Give to your son and his wife and that is $38,000. If both of you are giving, you are at $76,000 a year moving to that household with no forms, no note, and no escrow.
Compare that to the interest savings on a private mortgage and the gifting route usually wins outright. They go qualify for their own mortgage, which builds their credit and keeps the financial responsibility where it belongs. You supplement with an annual gift that more than covers the rate difference. Nobody is anyone’s bank.
You can also front-load it. If a larger gift toward the down payment is what actually moves the needle, do that instead, and exceeding the annual exclusion is far less dramatic than people believe. That $19,000 figure only functions as a hard ceiling if you expect to bump against the estate exemption, which currently sits near $30 million for a married couple. If your estate is realistically going to land at $10 or $15 million, gifting $300,000 toward a down payment simply reduces that exemption by $300,000. You file a return and move on. For most families that is a price of exactly zero.
If a Bank Would Not Lend to Them, Pay Attention to That
One last filter, and it is the one I want you to take most seriously. If the reason you are considering holding the note is that they cannot qualify for a mortgage on their own, stop and think about what you just learned.
A bank that underwrites loans professionally, with collateral and recourse, looked at their finances and declined. Why would you conclude that you should be the one to take that risk instead? Family does not change credit analysis. It only makes the conversation harder if the loan goes sideways. Keep the help simple, keep it a gift, and let the mortgage market do the part it is built to do.
This post is adapted from a recent episode of the Scholar Wealth Podcast. For more perspective on helping adult children buy a first home without creating tax or family complications, listen to the full podcast episode here.