Secured or Unsecured Promissory Notes and Private Lending

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If you're looking to use your self-directed IRA to invest in a private lending opportunity, it's important to understand the difference between secured and unsecured promissory notes before sealing the deal.

Your best friend from college, a stay-at-home dad, has decided to pick up a new hobby that will help him generate additional income for his growing family. After he and his wife remodeled and sold their first home for a sizable profit, your friend has decided to try his hand at fixing and flipping real estate. You've talked to your friend in the past about wanting to invest your self-directed IRA account into an alternative asset - something to distance your retirement from the potential volatility of Wall Street. Now he's approached you to ask if you'd be willing to invest in his next real estate fix-and-flip project. 

Before you agree to loan him the money from your self-directed retirement plan, you have to decide whether you want the note to be secured or unsecured. A promissory note is a written, signed, and dated contract that establishes the rights and duties of the parties involved in the loan agreement. The loan recipient agrees to pay a certain amount of money either on demand, at a specified time, or in installments to the lender. The amount due may include interest on the note's unpaid principal amount. In fact, IRA-owned promissory notes must incorporate an interest rate; the IRS does not allow "sweetheart" loans in an IRA.

A secured note is any debt secured by real property. This could include a first deed of trust, a vehicle title, or a certificate of deposit. An unsecured note is any note that is uncollateralized. You’ve known your friend for a long time and trust that he will repay the note, so you decide not to undermine your relationship by requesting a secured note.

However, your friend has student loans that he hasn't paid off and his wife is expecting another baby before the end of the year. You begin to worry that, without some form of collateral, your friend may run into financial trouble and you may have to accept a loss on the loan.

When considering a private lending opportunity with self-directed IRA, every investor may consider asking two key questions:

  • Is the investment viable? What is the estimated rate of return, and does the investment make financial sense on that basis? Will this investment produce suitable cash flow for your IRA account?
  • Is the investment a scam? Is it being proposed by a reputable and non-fraudulent source? Although you want to expand your IRA's investment opportunities, it's important to acknowledge possible drawbacks and faulty dealings with every prospective transaction.

Due diligence is not a perfect formula. Determining whether you want a secured or unsecured note from your loan recipient is completely up to you. However, a secured promissory note can help mitigatge the risk of being left empty-handed if your borrower gets into financial trouble. For more information about private lending with a retirement account or self-directed investing overall, please feel free to give us a call at 877-742-1270 or send us an e-mail at info@ndtco.com.

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