A promissory note is a legal agreement for one party to lend money to another, with terms and stipulations specifically outlined. In other words, it’s a contract for a promise to pay. You can use them in a ton of different ways, like offering private loans for qualified individuals, business loans to companies looking for financing, or even by acting as the “bank” in a real estate deal. The many uses for promissory notes are why they’re so popular, even outside of self-directed IRAs.
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 your note is secured, if at all. This can impact your options down the line, so it’s important to take it into consideration before investing.
1. Secured by Real Property (Mortgage Notes)
This asset class is a popular investment due to the benefits of receiving passive income from interest payments on a performing note.
Often investors will choose a secured promissory note because they 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 becomes a note investor by loaning
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.
There are companies that specialize in selling notes, buying mortgage notes and even managing the cash-flow for these investments. 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 promissory notes with non-real estate collateral. This means the note agreement is secured by some other form of collateral, such as physical property (like the title or pink slip to a car, farm equipment, or a 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, the note holder has the legal authority through the courts to take possession of the assets.
3. Unsecured Promissory 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 the note buyer offsets 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/Seller Financing
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).
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.
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.
Notes sold at discounted prices.
You can do a lot more with promissory notes than can be outlined here, but the flexibility and potential for a steady cash flow 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 that you’ve got the basics down, do you want to know more about the process of investing in promissory notes with IRAR? We’d love to help. Give us a call at 888-322-6534.