Secured or Unsecured Promissory Notes and Private Lending

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 a secured and an unsecured promissory note 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 as a novice real estate fix-and-flipper. You've talked to your friend in the past about wanting to invest your self-directed IRA account into an alternative asset - something more concrete than just stocks and bonds. Now he’s approached you to ask if you’d be willing to invest in his next real estate fix-and-flip project. He already owns the house, but he’s asking you to finance the remodeling of the property.

Before you agree to use your self-directed IRA account to loan him the money, you have to decide whether to request a secured or unsecured promissory note from your friend. 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.

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 trust your friend will repay the loan; you’ve known him a long time and don’t think he would take advantage of your generosity. You don’t want to undermine your relationship by requesting a secured note.

However, your friend does have some outstanding student loans from college that he still hasn’t paid off; not to mention his wife is expecting another baby before the end of the year. You’re afraid that without some form of collateral, he may run into financial trouble, and you’ll have to accept a loss on the loan.

When considering a private lending opportunity with self-directed IRA account, every investor should exercise two types of due diligence. First, is the investment viable? Meaning, what will be the estimated rate of return, and does the investment make financial sense? Will this investment produce a significant cash flow for your IRA account? Secondly, is this investment a scam? Is it being proposed by a reputable and non-fraudulent source? Although you want to expand your IRA’s investment opportunities and you want to help your friend with his fix-and-flip project, it’s important to acknowledge possible drawbacks and faulty dealings with every investment opportunity.
Before extending a private loan, every investor should “do the numbers” for the deal. Understand how to determine whether you are about to engage in a good or bad investment. How does the estimated cash flow of this investment compare with other opportunities? What is your personal risk tolerance?

With real estate, factors to evaluate may include physical inspections of the property, title company and insurance (make sure the person selling the property is the full legal owner), quality of neighbors, cost of utilities, HOA fees, property insurance, rental history & market rents (including surrounding properties), generating your own expenses (time and energy spent doing research on the property), among many other factors.

Due diligence is not a perfect formula. You may exercise extreme vigilance before evaluating an investment opportunity and still get taken advantage of – by a scam artist, or a well-meaning friend. Determining whether you want a secured or unsecured note from your loan recipient is completely up to you. However, a secured promissory note guarantees you won’t be left completely empty handed if your loan recipient gets himself into financial trouble – or if his wife has twins!

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