Either a Lender or a Borrower Be: Private Money Lending Out of Your IRA

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Personally, I think Shakespeare had it wrong when he penned this advice in Hamlet:  “Neither a borrower nor a lender be; For loan oft loses both itself and friend, And borrowing dulls the edge of husbandry.”  Perhaps he may be forgiven for his error, however, since Shakespeare suffered from a lack of the tremendous benefits of a truly self-directed IRA.

 

Money in self-directed IRAs can be loaned out to any person who is not a “disqualified person.”  While this means that you cannot loan yourself or other related disqualified persons money from your self-directed IRA, you can loan the money to anyone else.  Loans can be secured by real estate, mobile homes, equipment or anything you like.  If you are really a trusting soul, you can even make a loan from your IRA unsecured (although in that case I personally would tend to support Shakespeare’s advice).

 

First, let’s look at it from the borrower’s perspective.  At our office we offer a seminar entitled “Make Money Now With Self-Directed IRAs.”  One of the ways you can make money for yourself right now with your knowledge of self-directed IRAs is by creating your own “private bank.”  To do this, simply share the news that an IRA can be a private lender, refer people with IRA money to Quest to open a self-directed IRA, and then borrow their IRA money for your own financing needs.

 

With private financing the loan terms can be whatever the borrower and the lender agree to within the legal limits.  If you know a person who is getting 5% in a “safe” IRA at a bank, and you can offer them 9% secured by a first lien on real estate with only a 70% loan to value, would they be happy with that?  Even with a higher interest rate, private financing can work for you. IRA loans can be done quickly and without a lot of fees or fuss, which may mean you can get a deal which might be lost if you had to wait on the bank.  This is especially true in distressed sale situations, such as a pre-foreclosure purchase.

 

From a lending perspective, your IRA can grow at a nice rate while someone else does all the work.  In a typical hard money loan, the borrower even pays all of Quest’s modest fees as well as any legal fees for preparation of the loan documents.  True, you won’t hit a home run with lending, unless you are fortunate enough to foreclose on the collateral.  But the returns can be quite solid.  For example, by making very conservative hard money loans my Mom’s IRA has grown by about 10.5% in one year.  This is much better than the amount she was earning in her money market fund before she moved her IRA to an Quest self-directed IRA.

 

Even small IRAs can combine with other self-directed accounts to make a hard money loan.  My brother recently combined his Roth IRA, his traditional IRA, his wife’s Roth IRA, his son’s Roth IRA, his Health Savings Account (HSA), and 5 other IRAs to make a hard money loan.  The smallest IRA participating in this loan was for $1,827.00!  Each IRA made 2% up front and 12% interest on an 18 month loan, secured by a first lien on real estate with no more than 70% loan to value.

 

One thing to avoid in hard money lending is usury.  Usury is defined as contracting for or receiving interest above the legal limit.  The usury limit varies from state to state, with a few lucky states having no usury limit at all on commercial loans.  Some people have the theory of “What’s a little usury among friends?”  However, if the investment goes bad and your IRA has made a usurious loan, the consequences of the borrower making a claim of usury could include the loss of all the principal of the loan plus damages equal to 3 times the interest.  Some states even have criminal usury statutes.  It is best to consult with a competent attorney prior to making a hard money loan to make sure your IRA does not violate any usury laws.

 

To see how well hard money lending can work, let me give you an actual example.  One of our clients made a hard money loan from his IRA to an investor who purchased a property needing rehab.  The terms of the loan were 15% interest with no points or other fees except for the attorney who drew up the loan documents.  The loan included not only the purchase price but also the estimated rehab costs.  The minimum interest due on the loan was 3 months, or 3.75%.  The investor began the rehab by having the slab repaired, and before he could take the next step in the rehab process, a person offered him a fair price for the property as is.  The investor accepted the offer, and they closed about 6 weeks after the loan was initiated.

 

From the investor’s perspective, was this a good deal?  Yes, it certainly was!  True, he was paying a relatively high interest rate for the time he borrowed the money.  However, he was able to purchase a property with substantial equity which a bank most likely would not have loaned him money to buy due to the condition of the property.  Also, while the interest rate was high, the cost of financing was actually comparatively low.  With a normal bank or mortgage company there are fees and expenses incurred in obtaining the loan.  Common fees include origination fees, discount points, processing fees, underwriting fees, appraisal fees and various other expenses relating to the loan.  On the surface an interest rate may be 8%, but the cost of the financing is actually higher than 8% since a borrower has to pay the lender’s fees in addition to the interest on the loan.  Spread out over a lengthy loan term these additional fees do not add much to the cost of the financing.  However, if an investor has to pay all of these fees up front and then pays the loan off in only 6 weeks, the cost of the financing goes way up.

 

In this case the investor’s total loan costs were limited to 3 months minimum interest at 3.75% plus $300 in attorney’s fees for preparing the loan documents.  Best of all, the investor walked away from closing with $20,000 profit and no money out of his pocket!  Far from “dulling the edge of husbandry” this loan actually made the “husbandry” (ie. the purchase and resale of the property) possible.  Incidentally, the purchaser of the property was absolutely thrilled to get the property at less than full market value so that they could fix it up the way that they wanted it.

 

What about the lender in this case?  The lender was also quite happy with this loan.  His IRA received 3 months of interest at 15% while only having his money loaned out for 6 weeks.  For the 6 week period of the investment, his IRA grew at a rate of approximately 30% per annum!  Although his yield was above the legal limit for interest inTexason loans secured by real estate, prepayment penalties are generally not included in the calculation of usury here, so there was no problem.  The investor was happy, the new homeowner was happy, and the lender was happy.  Anytime you can create an investment opportunity with a win-win-win scenario, you should.

 

When I lecture about hard money lending, I ask the audience what they think is the worst thing that happens if you are a hard money lender.  Invariably, most people in the audience answer that you have to foreclose on the property.  Nonsense!  If you are doing hard money lending correctly, the worst thing that can happen is that the borrower pays you back!  Unfortunately, this is a common risk of hard money lending.  Most hard money loans are made at 70% or less of the fair market value of the property.  If you are fortunate enough to foreclose on a hard money loan, your IRA will have acquired a property with substantial equity while the investor did all the work of finding and rehabbing the property!

 

While it is true that foreclosing on a property owned by a friend may cause an end to that friendship, a properly secured hard money loan will at least not “lose itself” as Shakespeare asserts.  In fact, it may lead to substantial profit for your IRA!  To avoid losing a friend, simply don’t loan money from your IRA to someone you would feel bad foreclosing on.  In order to be a successful hard money lender, you do have to be prepared to foreclose on the property if necessary.

 

In modern times I believe the proper advice, at least in the right circumstances, is “Either a lender or a borrower be!”  You can make more money for yourself right now by borrowing OPI (Other People’s IRAs).  Borrowing from someone else’s IRA can even lower the total cost of your financing compared to a conventional loan from a bank or mortgage company, especially on short term financing.  From a lending perspective, your IRA can make great returns by being a hard money lender, either through higher than average interest rates or, better yet, through foreclosing on property with equity.  You may find that hard money lending from your self-directed IRA is a great way to boost your retirement savings without a lot of time and energy invested on your part.

 

Top Ten Things You Need to Know When Investing in Real Estate Notes with Your IRA

Investing in real estate notes with your IRA is one of the most popular self-directed IRA investments available. But with this popularity comes common mistakes when people lend their IRA (and non-IRA) money out, secured by liens on real estate. Follow these 10 tips to avoid potentially costly mistakes when choosing real estate as an IRA self-directed investment.

 

1) You may end up owning this piece of real estate if your borrower defaults. Never loan on something you wouldn’t want your IRA to own. The risk of loaning your IRA investments toward real estate notes is matched by the reward: I routinely see yields from these loans at 12% and higher; however, borrowers can default and you may be left with the property in foreclosure. If you would be upset by the potential of taking over this property in foreclosure, you probably should not make the loan.

 

2) Do not advance IRA money for home repairs until the repairs are finished; then have the repairs inspected before advancing the money. This is one of the biggest mistakes that I see clients make with their IRAs. They fund the full loan amount expecting that the repairs will be done on the property, but the borrower will actually need a little more money on another. If the loan goes bad, the IRA could end up with a property that hasn’t had the necessary repairs.

 

3) Do not loan money to someone you would feel uncomfortable foreclosing on. William Shakespeare wrote in Hamlet, “Neither a borrower nor a lender be/ For loan oft loses both itself and friend/ And borrowing dulls the edge of husbandry.” For the most part, I cannot agree with this advice, because lending and borrowing money drives our economy and increases economic activity. However, the part about a loan losing a friend is absolutely correct, in my opinion. If foreclosing on your borrower would cause you heartache, it is better not to make the loan. I have seen friendships destroyed over a loan gone bad.

 

4) If the loan goes into default, take action immediately. No one wants to admit that he or she has made a mistake in self-directed investing, but delaying action can be costly. You can always stop the foreclosure process once it has begun, but you cannot complete the process unless you start it.

 

5) Collect interest monthly so you will know if the borrower is getting into trouble. Many borrowers, especially investors, would prefer to pay interest at the end of the loan. But this exposes the lender to additional risk. The purpose of collecting payments monthly is both to:

 

  • Make sure the borrower remembers that he or she has to do something with that property in order to avoid the pain of the payment
  • Let you know if the borrower is in trouble because he or she starts missing payments

 

Keep in mind that unless you have contracted for monthly payments, you may not be able to foreclose, even if you do discover that the borrower is in financial trouble, because the loan may not be in default. This has actually happened to some of my clients.

 

6) If you are unsure about how to evaluate the loan, hire a professional to help you. Although a hallmark of the self-directed IRA is that it is “self-directed” — meaning that you make your own decisions and find your own investments — most IRA owners either do not possess sufficient knowledge or, in my case, sufficient time, to properly evaluate a loan transaction. My solution is to hire a professional to help me with the deals. He checks out the borrower, coordinates with the title company, orders the appraisal and usually a survey, makes sure insurance is in place and generally evaluates the loan. Naturally, he charges a fee for this service, which is passed through to the borrower on top of any interest and fees that my retirement plan may charge. This increases the cost of the loan; but in this case, the non-Biblical version of the golden rule applies, which is “He who has the gold makes the rules.”

 

7) Get title insurance for the loan. The purpose of title insurance is to shift risk away from you and to the title company. In Texas, where my office is, the incremental cost of title insurance is very small when issued in conjunction with an owner’s title policy. Regardless of the cost, making sure that your IRA is protected from title flaws is important.

 

8) Verify that hazard and, if necessary, flood insurance is in place, naming your IRA as an additional insured. It is very easy to miss this issue when you are trying to get everything completed right before a closing. Borrowers may get insurance at the last moment and simply forget to add your IRA as an insured. But if something goes wrong, you will want to make sure your IRA is named on the check.

 

9) Insist that the borrower provides you with evidence of payment when property taxes and homeowners association fees become due. The same thing would apply to hazard and flood insurance premiums, although normally you would receive notice of cancellation for non-payment of those bills. Depending on where you live, property tax bills can increase quickly due to penalties and court costs, which reduces your equity position in the property.

 

10) Get a personal guarantee if lending to an entity or to an individual with some weakness. When things are going well, you might be tempted not to insist on a personal guarantee, and indeed many borrowers will resist this. However, as we all have discovered recently, circumstances do change, and a personal guarantee may be helpful in collecting the debt. I collected on a note once where the property had decreased substantially in value due to vandalism and market conditions. Instead of foreclosing, I had my lawyer send a letter explaining to the guarantor, who had a significant amount of assets, that he was personally liable on the debt and that if he were unable to satisfy the note, I would pursue legal action against him and the borrower. A week later, a cashier’s check showed up that satisfied the lien.

 

There’s more to know when considering real estate for your self-directed IRA
This list of suggestions is not meant to be exhaustive. Other issues you will need to understand include:

 

  • Your lien position (personally, I only invest in first-lien loans)
  • Any state usury laws that might apply to the loan
  • At least a general idea of what the foreclosure process is in your state, in case the loan goes into default

 

Always get good legal counsel to assist you with loan documentation. Because the borrower traditionally pays for all expenses including legal fees, there is no reason not to have an attorney draw up loan documents.

 

Lending can be an excellent investment in an IRA. It is relatively easy to do and, if done correctly, has a comparatively low risk. Getting to know successful real estate entrepreneurs who borrow your IRA money may also lead to other, intangible benefits as well. Finally, be sure to learn the pointers for buying real estate with your self-directed IRA before you take any actions.

 

H. Quincy Long is a certified IRA services professional (CISP) and an attorney and is the president of Quest IRA, Inc., with offices in Houston and Dallas, Texas, as well as, Mason, Michigan. Email him at Quincy@QuestIRA.com.
Nothing in this article is intended as tax, legal or investment advice.