Setting up a private mortgage means structuring a real estate loan where an individual, rather than a bank, provides the financing, and then documenting it with the same legal instruments a commercial lender would use. Two documents do the work: a promissory note, which is the borrower’s personal promise to repay, and a mortgage or deed of trust, which attaches that promise to the property as collateral. Get either one wrong and you can lose a tax deduction, create an unenforceable lien, or draw IRS scrutiny for charging below-market interest. What follows is the sequence: agree on terms, set a defensible interest rate, draft the two instruments, clear title, sign and record, fund by traceable transfer, handle taxes, and release the lien when the loan is paid off.
Agree on the Loan Terms First
Before anyone drafts anything, both sides need every financial variable in writing. Full legal names. The exact principal amount. The payment interval, whether monthly, quarterly, or something else. A maturity date. Private mortgages commonly run 5 to 30 years, and the term length feeds directly into the minimum interest rate the IRS will accept.
Decide the structure next. A fully amortized loan spreads principal and interest evenly so the balance reaches zero at maturity. A balloon loan keeps monthly payments low and demands a lump sum at the end. Balloons are popular in private lending 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, the lender is left initiating foreclosure or renegotiating under pressure.
A handful of provisions belong in every private mortgage agreement:
- Late fees, with a grace period (commonly 10 to 15 days) and a penalty amount, often 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.
- A due-on-sale clause. This lets the lender demand full repayment if the borrower sells or transfers the property without consent. Without it, a new owner could assume the loan at the original rate even after market rates have climbed.
- A requirement that the borrower maintain homeowners insurance and stay current on property taxes. An uninsured casualty or a tax lien can wipe out the collateral. Some private lenders collect monthly escrow deposits to cover both, though federal escrow rules under RESPA generally apply only to federally related mortgage loans, not purely private arrangements.
Set an Interest Rate the IRS Will Accept
The IRS publishes Applicable Federal Rates every month in three tiers based on loan term: short-term (up to three years), mid-term (three to nine years), and long-term (over nine years).1Internal Revenue Service. Applicable Federal Rates A private mortgage’s 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 is 4.72%, the mid-term is 3.93%, and the short-term is 3.59%.2Internal Revenue Service. Rev. Rul. 2026-6 The rates shift monthly, so pull the table for the month your loan closes.
Charging less than the AFR triggers federal imputed interest rules. Under 26 U.S.C. ยง 7872, the IRS treats a below-market gift loan as though the lender made a gift to the borrower equal to the forgone interest, and the borrower then paid that amount back as interest.3Office of the Law Revision Counsel. 26 USC 7872 – Treatment of Loans With Below-Market Interest Rates The lender ends up owing income tax on interest never collected, and the below-market portion may count as a taxable gift. Family loans get tripped up here most often, because the instinct is to charge a low rate as a favor. You can still offer a rate well below what a bank would charge. Just clear the AFR floor for your term.
At the other end, watch state usury limits. Every state caps the maximum interest rate for certain loan types, with ceilings running roughly 5% to 25% depending on the state and transaction type. Charging above the cap can void the interest entirely or expose the lender to statutory penalties. If your rate is much higher than a bank would offer, check the usury statute before finalizing.
Whether You Need a License
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 who provides financing for the sale of their own property, or a parent financing a loan to their child, is not considered to be in the business of loan origination as 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 (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 private 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 apply once you provide financing on 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 serious penalties. Planning more than a single loan? Get legal advice before proceeding.
The Two Documents You Need
Every private mortgage requires two separate instruments. Confusing them is a common mistake, because they do different jobs.
The Promissory Note
The promissory note is the borrower’s personal promise to repay. It contains the principal amount, the interest rate, the payment schedule, the maturity date, late fee terms, and prepayment provisions. It creates a personal obligation between the two parties. If the borrower defaults, the note is what allows the lender to pursue the borrower for the money owed, even beyond the value of the property. The note stays with the lender until the debt is satisfied.
The Mortgage or Deed of Trust
The security instrument, called a mortgage in some states and a deed of trust in others, ties the debt to the property. It gives the lender a legal claim (a lien) against the real estate. Without this document, properly recorded, the lender has 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.
Either a real estate attorney or a legal document service can prepare both documents. For a loan of any real size, an attorney review costs little compared to the risk of a defective instrument. State recording requirements vary enough that a template pulled off the internet may not work in your county.
Run a Title Search Before You Record
Before recording the mortgage, order a title search on the property. A title search examines public records to confirm the borrower actually owns the property and to surface any existing liens, unpaid taxes, easements, or legal disputes that could affect the collateral. If a bank already holds a first mortgage, your lien will be junior to it, meaning in a foreclosure the first lienholder gets paid before you see a dollar.
A professional title search typically costs $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, including forged documents in the chain of title or undisclosed heirs with a legal claim. The lender’s policy is issued for the loan amount and stays in effect until the loan is paid off. Skipping the title search to save a couple hundred dollars is one of the worst economies a private lender can make.
Sign, Notarize, and Record
Once the documents are finalized, both parties sign the security instrument in front of a notary public. The notary verifies identities and applies an official seal, which is required for the document to be accepted for recording. Notary fees for a standard acknowledgment run $2 to $25 depending on the state, with most charging 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 the 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 determines whether the borrower can deduct mortgage interest. IRS Publication 936 says 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 range from $50 to $150 for the first few pages. Once processed, the office stamps the document with a recording reference (book and page number or instrument number) and returns it to the lender.
Fund the Loan Through a Traceable Transfer
With the documents signed and the lien recorded, the lender transfers 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. A personal check is not appropriate for a real estate closing, and title companies and closing agents generally won’t accept one. Keep the wire confirmation or cashier’s check receipt in your loan file. If the transaction is ever questioned by the IRS or in litigation, the funding record is the lender’s proof that actual money changed hands rather than a disguised gift.
Track Payments and Report the Interest
Once the loan is active, the lender needs a system for tracking each payment, how much goes to interest versus principal, and the remaining balance. Spreadsheets work for small loans, but many private lenders hire a third-party loan servicing company. A servicer handles payment collection, generates year-end tax documents, sends late notices, and maintains an escrow account if the loan requires one. Cost typically runs $15 to $50 per month.
Lender’s Tax Reporting
Interest received on a private mortgage is taxable income, reported on your federal return. One point worth flagging: there is no “Form 1098-INT.” The correct form for reporting mortgage interest is Form 1098, and only someone who receives mortgage interest “in the course of a trade or business” is required to file it.6Internal Revenue Service. Instructions for Form 1098 Most one-time private family lenders do not meet that test.
You still owe tax on the interest income. Report it on Schedule B of your Form 1040. If the borrower pays $10 or more in interest during the year, the borrower may also need to send a Form 1099-INT.7Internal Revenue Service. About Form 1099-INT, Interest Income Whether or not any tax form arrives, the income is reportable.
Borrower’s Deduction
The borrower can deduct mortgage interest on a private loan 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 has to itemize on Schedule A to claim it. And the security instrument has to be recorded. An unrecorded private mortgage fails the “secured debt” test and the borrower loses the deduction.5Internal Revenue Service. Publication 936, Home Mortgage Interest Deduction
If the Borrower Defaults
A properly recorded mortgage or deed of trust gives the lender the right to foreclose if the borrower stops paying. How that works depends on the state and on which security instrument was used.
States that use mortgages generally require judicial foreclosure. The lender files a lawsuit, the court issues a judgment, and the property is sold at a court-supervised auction. This can take months to years. States that use deeds of trust typically allow nonjudicial foreclosure, where the lender or a trustee named in the deed of trust follows a statutory notice procedure and sells the property without court involvement, usually within a few months. Some states allow both methods, and a handful use nonjudicial foreclosure with partial court supervision.
Before a foreclosure sale, most states give the borrower a chance to cure. A right of reinstatement lets the borrower 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 the borrower pay off the full remaining balance before the sale. Some states allow redemption for a statutory window after the sale as well.
Private lenders often underestimate how expensive and slow foreclosure can be. Attorney fees, court costs, property maintenance during vacancy, and the time value of money all eat into whatever the lender recovers at auction. That’s why the upfront steps matter so much. A well-papered loan with a borrower who can actually afford the payments rarely lands in foreclosure.
Release the Lien When the Loan Is Paid Off
When the borrower makes the final payment, the lender’s job isn’t done. The lender has to prepare and record a document that clears the lien from the property’s title. In mortgage states, this is called 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 the loan is paid in full. Missing the deadline can expose the lender to penalties and leaves a cloud on the borrower’s title that will block a future sale or refinance. This is an easy step to forget in a private arrangement between family, but until the release is recorded, public records still show a lien on the property.
Keep the original promissory note in a safe place throughout the life of the loan. When the debt is satisfied, mark the 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 on both sides.