How to use a gift letter for your mortgage
Coming up with the money for a down payment is arguably the biggest financial obstacle first-time homebuyers face. If you want to avoid paying private mortgage insurance (PMI) on a conventional home loan, you’ll need to put up 20% of the purchase price. That’s no easy feat when you’re dealing with asking prices that can add up to hundreds of thousands of dollars.
There are a lot of different ways to work around this potential roadblock. For instance, government-backed loans like FHA, VA and USDA loans often have flexible down payment options. But there are always going to be tradeoffs to consider with those loan options.
Arguably one of the easiest ways to cover your down payment requirements, avoid PMI and secure a favorable interest rate is to ask a family member or close friend to help cover those up-front costs. If you receive that kind of financial assistance, though, you’ll need to document it for your lender. That’s where a gift letter comes into play.
Lenders have different rules and guidelines for you to follow with this paperwork, depending on the type of loan and transaction. Be sure you understand exactly how gift letters work so you’re able to provide the right documentation when you buy a house.
What is a gift letter?
The so-called “20% rule” is one of the biggest mortgage myths out there — and one we’re all too happy to debunk. You don’t need to put forward that much money to pay your down payment. That being said, if your down payment is less than 20% of the purchase price (on a conventional loan that is; there are different rules for government loans), then you’ll need to add PMI to your monthly housing costs.
First-time homebuyers would understandably want to avoid that extra expense, and many will turn to family members to help cover the gap and reach that 20% equity threshold. Receiving financial assistance to pay for the down payment on your first house is extremely common, but you’ll need to explain to your lender where that money came from.
Gift letter definition
A gift letter is a document certifying that your family member is giving you money to cover all or a portion of your down payment or closing costs. This note will also stipulate that the gifted funds are not considered a loan. That is, the donor — i.e., your relative — doesn’t expect you to pay back that money.
Your parents can’t just write a note by hand saying they’re giving you money — that’s not sufficient documentation for your lender. Gift letters need to contain specific information to be considered valid, which we’ll get into in just a moment. They’re usually written on standardized forms provided by your bank or credit union, so you shouldn’t have much trouble filling in the necessary details.
Why do lenders require gift letters?
As you may already know, the average home loan takes anywhere from 30 days to 45 days to close. What’s the holdup? In a word: underwriting. Lenders want to minimize their risk exposure as much as possible, and that means digging through your finances and determining if you can afford your mortgage.
If you’re using funds from a third party to cover your upfront costs, then lenders will need to verify that money is actually a gift and not a loan. Because if it is a loan, then you have more debt than initially disclosed when you were prequalified. And that could negatively impact your lending qualifications. That’s also why a simple, handwritten note won’t suffice here. You need a certified document attesting to the intent of the donor to satisfy your lender.
Who can give you gift money?
Lenders are OK with borrowers using down payment gifts as long as the donor shares a close relationship that — and this is the important part — can be documented. As such, family members are your best bet: parents, siblings, grandparents, aunts, etc.
Some types of loans may have more stringent guidelines to follow than others. For instance, Fannie Mae- or Freddie Mac-backed loans could exclude close friends or roommates from the list of acceptable donors. FHA loans, meanwhile, allow gifts from close friends and even nonprofits, but may not approve monetary funds given to you by your cousins. So, with all that in mind, you’ll want to closely review the gift letter requirements for the loan types you’re considering before applying for a mortgage.
Are there limits on acceptable gifts?
Don’t feel like you can only use gift money for a down payment. You can spend a monetary gift on just about any expense related to a home purchase, including closing costs:
The gift money could cover all or just a portion of those expenses. If you wanted, you could combine funds in your savings account with a wire transfer from your parents’ account to cover the full cost of your down payment.
In many cases, there’s no limit on the amount of money that can come from a monetary gift. Keep in mind, though, that lenders may require borrowers to pay a certain percentage of the down payment out of pocket under certain circumstances — buying an investment property, for instance. Here’s how some of the most common loan options handle gift limits:
- FHA loans: No limit
- VA loans: No limit (VA loans actually have down payment options as low as 0%)
- Fannie Mae-backed loans: Buyer must provide 3% down payment option
- Freddie Mac-backed loans: No limit
What should you include in a gift letter?
As we noted earlier, gift letters are usually written using a standardized form, so your bank or lender should provide a mortgage gift letter template. Even so, you’ll want to familiarize yourself with the information required in these documents.
Donors are often unaware that they need to fill out an additional form to help out with a down payment. They may even chafe at the idea of someone else’s mortgage company taking a deep dive into their financials. There’s a lot of potential for misunderstandings in these scenarios, so it’s best to come to the table with crystal-clear expectations.
- Donor’s name
- Donor’s relationship to borrower
- Gift money amount
- Name of the bank or credit union
- Type of account
- Account number
- Donor’s contact info
- Donor’s signature
- Borrower’s signature
Does a gift letter need to be notarized?
Nope. Lenders do not require notarized gift letters, just as long as all the information listed above is included. Assuming your down payment gift letter uses a standardized form from a recognized financial institution, you should be fine.
What a gift letter looks like
Although these documents tend to be pretty standardized, each financial institution could use its own gift letter template. In the interest of knowing what information to look for, let’s review a sample gift letter for a mortgage:
Gift letter template
Gift Letter (Header)
We certify that we are gifting [borrower’s name] the sum of [gift amount].
Relation to borrower/purchaser:
Funds from this gift will be used to purchase property at [address].
We confirm that this gift does not constitute a loan and will not be repaid by the purchaser.
The source of this gift is: [bank’s name and account information]
How to write a gift letter for a mortgage
As noted earlier, your bank should provide a gift letter template for you to complete. Filling in the required information should be pretty straightforward, but some gift letter forms can be fairly open-ended, giving donors more space to add extra details and context.
That’s not really necessary, though, even if you’re a first-time homebuyer. A good general rule to follow is to keep things brief and to the point. Stick to the basic facts: your relationship, the amount of money being gifted and a clear statement verifying that those funds are not a loan. Those are the most important details a lender will want to see. How your parents earned that money in the first place isn’t all that relevant, so don’t include such extraneous information.
Gift letter vs. gift of equity letter
A gift of equity is a very different transaction than a standard monetary gift and requires its own distinct gift letter as a result. Here’s a quick overview of how it works: A family member could choose to sell their home to you at a lower price than its fair market value. The difference between the home’s property value and the sale price would, in essence, be a gift of equity. Not only are you getting the house at a discount, but you’re also gaining a large chunk of home equity right off the bat. In that scenario, a lender would require a gift of equity letter to better understand the somewhat unusual circumstances surrounding the transaction.
A gift of equity letter includes many of the same details as a gift letter for a loan, but rather than list the amount of money being given, it’ll instead state how much equity is being transferred to the new homeowners. There’s an extra step in the process that you and your relatives will need to consider too: the home appraisal. Hiring a professional appraiser to assess the property’s market value usually falls on the buyer, but in this situation, the seller may want to set that up themselves to avoid any potential complications.
Do donors pay taxes on monetary gifts?
The short answer is: sometimes. As of 2022, the IRS allows an exclusion on any gift valued at less than $16,000. What that means is you don’t have to pay taxes on a monetary gift unless you’re giving someone more than $16,000 in a given year. And that exclusion changes on an annual basis too. The tax exclusion for 2022 is $1,000 more than it was the previous year.
The potential wrinkle here is that while $16,000 is a lot of money, it alone may not cover the full down payment on a house — at least if you’re trying to acquire 20% equity and avoid PMI. For reference, $16,000 is the equivalent to a 20% down payment on a house listed at $80,000. Good luck finding homes at that price point in today’s competitive real estate market.
To avoid paying a gift tax to the IRS, you would otherwise need to combine those gifted funds with your own money to make a down payment. Otherwise, if your family members pay the down payment in its entirety, then they would likely need to pay taxes on that gift.
Tax rates of monetary gifts can vary depending on a number of different factors that are too complex to do justice here. As with any matter involving taxes, we always strongly advise that you consult a certified tax advisor to learn more.
Lenders usually allow borrowers to use monetary gifts from relatives and close friends when buying a house. Before approving your mortgage application, though, they’ll want to be sure that money isn’t considered a loan itself. In these situations, you’ll need to submit a gift letter to verify the pertinent details regarding that money.
Gift letters are relatively easy to acquire and, thanks to standardized forms and templates, filling them out should be pretty straightforward. Even so, it’s very important that all the information included in this paperwork is completely accurate and up to date. Any issues with your gift letter could impact your loan application, delaying approval or perhaps even resulting in a rejection. If you have any questions or concerns about gift letters, be sure to contact a loan expert who can review your specific circumstances and advise you on the best course of action.
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