Secured or Unsecured
Promissory Notes: Due Diligence and Private Investing
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.
Patricia McCrystal
July 10th, 2015
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!
