To set up a private mortgage, you negotiate the loan terms with the borrower, confirm the interest rate meets the IRS minimum for the month, draft a promissory note and a mortgage or deed of trust, run a title search on the property, sign and notarize the security instrument, record it with the county, and then fund the loan with a traceable transfer. Each step protects something specific: the note protects your right to collect, the recorded lien protects your claim to the property, and the correct interest rate protects you from the IRS treating your deal as a disguised gift. Skipping any one of them can cost the borrower a tax deduction, cost you an enforceable lien, or trigger imputed interest on money you never collected.
Agree on the Loan Terms
Start with the variables. Full legal names of both parties, the exact principal, the payment interval (monthly, quarterly, or something else), and a maturity date. Private mortgages commonly run 5 to 30 years, and the length matters beyond scheduling: the term bracket determines which IRS minimum rate applies.
Decide the structure next. A fully amortized loan spreads principal and interest evenly so the balance hits zero at maturity. A balloon loan keeps monthly payments low and leaves a large lump sum due at the end. Balloons are popular in private deals because they ease the borrower’s monthly burden, but they carry real risk. If the borrower can’t refinance or pay the balloon when it comes due, you’re left starting a foreclosure or renegotiating under pressure.
A few provisions belong in every private mortgage agreement:
- Late fees. Specify the grace period (commonly 10 to 15 days) and the penalty, usually a percentage of the overdue installment.
- Prepayment terms. State whether the borrower can pay off early and whether any penalty applies. Most private deals allow prepayment without penalty, but say so either way.
- Due-on-sale clause. This lets you demand full repayment if the borrower sells or transfers the property without your consent. Without it, a new owner could assume the loan at the original rate even after market rates climb.
- Property taxes and insurance. Require the borrower to keep homeowners insurance in force and property taxes current. An uninsured casualty or a tax lien can wipe out your collateral. Federal escrow rules under RESPA generally apply only to federally related mortgage loans, not purely private arrangements, so if you want an escrow you have to build it into the contract.
Set the Interest Rate Above the AFR
The IRS publishes Applicable Federal Rates every month in three tiers: short-term (up to three years), mid-term (three to nine years), and long-term (over nine years).1Internal Revenue Service. Applicable Federal Rates Your private mortgage rate must meet or exceed the AFR for the month the loan is made. As of March 2026, the long-term AFR for annual compounding sits at 4.72%, the mid-term at 3.93%, and the short-term at 3.59%.2Internal Revenue Service. Rev. Rul. 2026-6 Rates shift monthly, so pull the table for the month you close.
Charging less triggers imputed interest rules. Under 26 U.S.C. ยง 7872, the IRS treats a below-market gift loan as if you gifted the borrower the forgone interest and the borrower paid it back to you as interest.3Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates You end up owing income tax on interest you never collected, and the below-market portion may count as a taxable gift. Family lenders get caught here most often, because the instinct is to charge a token rate as a favor. You can still offer a rate well below what a bank charges. Just make sure it clears the AFR for your loan term.
On the other end, state usury limits cap the maximum rate for certain loan types, with ceilings running roughly 5% to 25% depending on the state and transaction type. Charging above the limit can void the interest entirely or expose you to statutory penalties. If your rate is noticeably higher than a bank would offer, check your state’s usury statute before signing.
Check Whether Licensing Rules Apply to You
Federal law generally does not require a private individual to hold a mortgage originator license for a one-off family loan. Under the SAFE Act’s implementing regulation, a person financing the sale of their own property, or a parent lending to their child, is not considered to be in the business of loan origination so long as the activity is not habitual or commercial.4eCFR. 12 CFR Part 1008 – SAFE Mortgage Licensing Act, State Compliance and Bureau Registration System The Dodd-Frank Act separately exempts sellers who finance no more than three properties in any 12-month period, provided the loan is fully amortized with no balloon, the rate is fixed or adjustable only after five or more years with reasonable caps, and the seller determines in good faith that the borrower can repay.
Repeat lenders are a different story. If you regularly fund mortgages as a business activity, you likely need a state mortgage lender or originator license, and federal ability-to-repay rules under the Truth in Lending Act kick in once you finance more than five properties in a calendar year. The line between a private favor and a regulated lending business turns on frequency and intent, and crossing it without a license carries real penalties. Planning more than one loan? Get legal advice first.
Draft the Promissory Note and the Security Instrument
Every private mortgage requires two separate documents. They do different jobs, and confusing them is a common mistake.
The Promissory Note
The note is the borrower’s personal promise to repay. It contains the principal, interest rate, payment schedule, maturity date, late fee terms, and prepayment provisions. It’s a contract between two people, and it creates a personal obligation. If the borrower defaults, the note is what lets you pursue them for the money owed, even beyond the value of the property. Keep the original in a safe place for the life of the loan.
The Mortgage or Deed of Trust
The security instrument ties the debt to the property. Some states call it a mortgage, others a deed of trust. It gives you a legal claim (a lien) against the real estate. Without this document, properly recorded, you have no right to foreclose and the borrower cannot deduct mortgage interest on their taxes. The security instrument must include the exact legal description of the property, which you can pull from the most recent deed. Copy it precisely. Errors in the legal description can render the lien unenforceable.
Both documents can be prepared by a real estate attorney or through a legal document service. For a loan of any size, the cost of an attorney review is trivial next to the risk of a defective instrument. State recording requirements vary enough that a template downloaded from the internet may not work in your county.
Run a Title Search
Before you record anything, order a title search. The search examines public records to confirm the borrower actually owns the property and to surface any existing liens, unpaid taxes, easements, or legal disputes affecting the collateral. If a bank already holds a first mortgage, your lien will be junior to it, which means in a foreclosure the first lienholder gets paid before you see a dollar.
A professional title search typically runs $75 to $200 for a residential property. Many private lenders also buy a lender’s title insurance policy, which protects against defects the search might miss, such as forged documents in the chain of title or undisclosed heirs with a claim. The policy is issued for the loan amount and stays in effect until payoff. Skipping the title search to save a couple hundred dollars is one of the worst economies in private lending.
Sign, Notarize, and Record
Both parties sign the security instrument in front of a notary public. The notary verifies identities and applies an official seal, which recording offices require. Notary fees for a standard acknowledgment run $2 to $25 depending on the state, with most around $5 per signature.
The signed and notarized security instrument then goes to the county recorder’s office (sometimes called the registrar of deeds) in the county where the property sits. Recording creates a public record of your lien and establishes its priority date. The earlier the recording, the higher the priority relative to future claims against the property. This step is not optional. An unrecorded mortgage is invisible to the world, which means a later lender or buyer could take the property free of your lien.
Recording also controls the borrower’s ability to deduct the interest. IRS Publication 936 states that a mortgage must be “recorded or otherwise perfected under any state or local law that applies” to qualify as secured debt eligible for the interest deduction.5Internal Revenue Service. Publication 936, Home Mortgage Interest Deduction Skip recording and the borrower loses the deduction entirely.
You can file in person or by certified mail depending on the county. Recording fees generally run $50 to $150 for the first few pages. The office stamps the document with a recording reference (book and page number, or an instrument number) and returns it to you.
Fund the Loan
With the documents signed and the lien recorded, transfer the principal to the borrower or a closing agent. Use a wire transfer or cashier’s check. Both create a clear paper trail and provide immediate availability of funds. A personal check is not appropriate for a real estate closing, and title companies and closing agents generally won’t accept one. Keep a copy of the wire confirmation or the cashier’s check receipt in your loan file. If the IRS or a court ever questions the transaction, the funding records are your proof that actual money changed hands rather than a disguised gift.
Track Payments and Handle the Taxes
Once the loan is active, you need a system for tracking every payment, how much goes to interest versus principal, and the remaining balance. Spreadsheets work for small loans. Many private lenders hire a third-party loan servicing company that handles collection, year-end tax documents, late notices, and any escrow. Expect roughly $15 to $50 per month depending on the servicer and loan complexity.
What the Lender Reports
Interest you receive is taxable income. Form 1098 only needs to be filed by someone who receives mortgage interest “in the course of a trade or business,” and the IRS instructions give the explicit example of a physician who lends money to sell a personal home as someone who does not need to file.6Internal Revenue Service. Instructions for Form 1098 Most one-time private family lenders fall in that same category. You still owe tax on the interest. Report it on Schedule B of your Form 1040. If the borrower pays you $10 or more in interest during the year, they may also need to send you a Form 1099-INT.7Internal Revenue Service. About Form 1099-INT, Interest Income The income is reportable whether or not you receive a form.
What the Borrower Can Deduct
The borrower can deduct mortgage interest on a private loan, but only if the loan qualifies as “acquisition indebtedness,” meaning it was used to buy, build, or substantially improve a qualified residence and is secured by that residence.8Office of the Law Revision Counsel. 26 U.S. Code 163 – Interest The borrower must itemize on Schedule A to claim it. And the security instrument must be recorded. An unrecorded private mortgage fails the “secured debt” test under IRS rules and the borrower loses the deduction.5Internal Revenue Service. Publication 936, Home Mortgage Interest Deduction
Know What Default Looks Like
A properly recorded mortgage or deed of trust gives you the right to foreclose if the borrower stops paying. How that plays out depends on your state and on which security instrument you used. Mortgage states generally require judicial foreclosure: a lawsuit, a judgment, and a court-supervised auction. That can take months to years. Deed of trust states typically allow nonjudicial foreclosure, where the lender or a named trustee follows a statutory notice procedure and sells the property without court involvement, usually within a few months. Some states allow both.
Before a sale, most states give the borrower a chance to catch up. A right of reinstatement lets them pay past-due amounts plus fees and return the loan to current status. A right of redemption, which exists in some form in every state, lets them pay the full remaining balance before the sale. Some states extend redemption into a window after the sale.
Private lenders routinely underestimate how expensive and slow foreclosure is. Attorney fees, court costs, property maintenance during vacancy, and the time value of money all eat into whatever you recover at auction. That’s why the upfront steps matter so much. A well-papered loan to a borrower who can actually afford the payments rarely ends up in foreclosure.
Release the Lien at Payoff
When the borrower makes the final payment, your job isn’t finished. You have to prepare and record a document clearing the lien from the title. In mortgage states this is a satisfaction of mortgage or release of mortgage. In deed of trust states, the trustee issues a deed of reconveyance.
Most states impose a statutory deadline for recording the release, typically 30 to 90 days after payoff. Missing it can expose you to penalties and creates a cloud on the borrower’s title that can block a future sale or refinance. It’s an easy step to forget in a family arrangement, but public records keep showing a lien on the property until the release is filed.
When the debt is satisfied, mark the original note “Paid in Full,” sign and date it, and return it to the borrower along with a copy of the recorded lien release. That closes the loop cleanly for both sides.