Why not take a typical private loan agreement and make it all your own? When investing in promissory notes with your self directed IRA, you can do it (almost) any way you please.
A promissory note is a legal agreement for one party to lend money to another, with terms and stipulations outlined specifically. You can use them in a ton of different ways— from offering private loans for qualified individuals, business loans to companies looking for financing, even by acting as the “bank” in a real estate deal— which is why they’re so popular, even outside of self direction.
Different Kinds of Promissory Notes
There are two main categories of promissory notes (secured and unsecured), but they’re generally broken into three types:
- notes secured by real property
- notes secured by non-real estate
- unsecured notes
The biggest difference? How is your note secured— if at all. This can impact your options down the line, so it’s important to take into consideration before investing.
|Quick Compare: Promissory Notes|
|Secured by Real Property||Secured by Non-Real Estate||Unsecured|
|A promissory note secured by real estate collateral.||A promissory note secured by a non-real estate asset.||A promissory note not secured by any property or collateral, though typically with higher interest rates.|
|AKA: Mortgage Note, Deed of Trust, Deed of Mortgage||AKA: Secured Note, Personal Note, Note Agreement||AKA: Personal Note, Note Agreement|
|Example: A loan to buy a single-family home, with the home as collateral||Example: A loan to a construction company, with the equipment as collateral||Example: A loan to a restaurant, with repayment terms but no collateral|
1. Secured by Real Property (Mortgage Notes)
Often investors want to invest their retirement savings into real estate, but don’t want to deal with the work of becoming a landlord. With mortgage notes, you can do just that. Acting as the bank, your IRA loans funds to the borrower— but with the property itself listed as collateral in case of default. This way, even if your borrower stops paying, you still have recourse and can take ownership of the property. Check out our blog on investing in mortgage notes with your self directed IRA if you’re looking for more information on how to go about this process.
2. Secured by Non-Real Estate
Self directed investors can also secure their promissory notes with non-real estate collateral. This means the note agreement is secured by some other sort of collateral, be it physical property (like the title or pink slip to a car, farm equipment, or a UCC lien or filing on a business) or non-tangible assets (like intellectual property rights). If the borrower reneges, stops making payments, or otherwise breaks the outlined terms, you have the legal authority through the courts to take possession of the assets.
3. Unsecured Notes
When investing with an unsecured note, investors outline an agreement and terms as discussed above, but there is no collateral if the borrower somehow breaks the agreement. Often investors try to make up for this potential risk with stronger pre-screening techniques and higher interest rates, but they do still come with risks. Yet these notes are still popular with investors, likely due to the ease and availability of borrowers.
Like all investments, promissory notes do come with risks— a survey by the North American Securities Administrators Association found that notes were the most frequent source of investor complaints and investigations. Self Directed IRA custodians do not vet your investments, and IRAR is no exception. Be sure to do your due diligence: research the investment and borrower ahead of time, along with IRS compliance, to protect your account. We’re happy to help explain these rules for self directed IRAs if you have questions.
Other Types and Terms of Promissory Notes
Not only are there different ways of referring to various promissory notes depending on where you are, there are also more strategies and options than you could imagine— since each note is customized for each individual arrangement. Here are some other varieties of promissory notes you can hold in your self directed IRA:
- Fractionalized Trust Deed/Mortgage
- This is a mortgage note where there are multiple lenders in one loan.
- Seller Carry-Back Note/Take Back Mortgage
- This is a mortgage note where the original owner still holds the contract with the original lender (carrying/taking it back) and the buyer signs a promissory note, outlining the terms of the deal (like the price of the property and interest rate).
- Corporate Note
- This is a secured note, often offered by a company once they have exhausted traditional methods of funding. They generally have a higher risk of default than bonds sold by the same organization, but to compensate they typically have higher interest rates. These types of notes are often bought and sold among investors.
- Convertible Note
- Offered by some companies, this is effectively a combined note, with elements of both equity and a loan. It starts out as a typical secured note, with the borrower paying interest— but the lender has the option to, as some point, convert their loan to stock shares (when and how should be spelled out in the original note agreement).
- Note Participation Agreement
- This is an agreement where investors can buy portions of an outstanding loan or package of loans. The exact terms, structure, and financing of these agreements varies wildly between providers, so be sure to clarify specifics when investing.
There’s a lot more you can do with promissory notes than can be outlined here, but the flexibility and potential for a steady investment independent of the stock market is particularly appealing to many investors. The choices for strategy, note structure, and eventual payoff are huge— if you can think it, it’s probably possible (but make sure it’s allowed in your self directed IRA first).
Now you’ve got the basics down— want to know more about the process of investing in promissory notes with IRAR? If you can’t find what you need through our educational resources, please submit a question and we’d love to help answer your questions.