One of the lesser known investment assets enabled by a Self Directed IRA is the promissory note. Let’s break down how a promissory note works, how a Self Directed IRA can invest in one, and what are some of the pitfalls that should be avoided.
What is a Promissory Note?
A promissory note is in its essence a bill of debt. The investor gives over funds to a company or individual, and the recipient in turn promises to pay back the money with a certain amount of interest. In some areas a promissory note can be referred to as a “note payable”. One of the key elements of its utility is that can secure funding without having to go through a standard financial institution.
What Are The Different Kinds of Promissory Notes?
Certain financial niches have grown to use promissory notes as their go-to financial instrument. Here are some of the most common:
- Private Loans – These come in a great variety of formats and offer the chance for a mutually beneficial interaction. The borrower gets to access funding for a small business (or other investment) without the long and strenuous process of a bank loan. The lender profits from a hands-off investment with a decent return.
- Student Loans – Many students fund their higher education by utilizing private lenders or governmental programs. For federal student loans, there is often one master promissory note that the student will sign at the beginning of the process.
- Mortgages – A common use of promissory notes is to make purchasing a home possible for somebody who wouldn’t necessarily qualify for a standard mortgage. In this case a private lender will put up the funds and then hold the deed to the property as collateral. The borrower will repay the loan like a standard mortgage with set monthly payments at an appropriate interest rate. The lender can even ask for a normative down payment to bolster confidence in the deal.
- Corporate Credit – A promissory note can be used to provide company funding, either for short term cash flow or as investment capital. When used for investing purposes, the note has to be registered with the Securities and Exchange Commision. These type of promissory notes are often higher risk and consequently offer a higher interest rate as well. If the note is pushed out without SEC registration, all due diligence will fall solely on the individual investor.
Which Self Directed IRA Account Is The Best For Investing in Promissory Notes?
There is no one right answer. It depends on the details of the deal and how this investment will fit into the greater scheme of your retirement investing. However, we can take a look at a fairly common scenario and make a determination for that given case.
Susan and Rick want to buy a house. They each have good paying jobs and have saved enough for a nice sized down payment. However, they are having trouble securing a mortgage because of a bankruptcy a few years back. After exploring different possibilities, Susan remembers that her cousin Kaye had offered to help with a loan. Kaye is amenable to the proposition and asks Susan and Rick to give her a few days for research. She heard that she might be able to use a Self Directed IRA for the loan and she wants to find out how the process works.
In Kaye’s research she finds that there are many ways to set up a Self Directed IRA but overall they provide two kinds of functionality. One is a custodian-based Self Directed IRA where all transactions go through the custodian. The second is a Checkbook Control Self Directed IRA where the IRA is set up with a checking account and the account holder can perform transactions on their own.
If Kaye were to call a Madison specialist, she would probably be told that in this specific case the custodian-based Self Directed IRA is the way to go. This is because as the investment stands now it will have very few transactions. There will just be the initial loan and the deposit of the monthly payment. A custodian-based Self Directed IRA offers very economical setup and, once it gets going, fairly hands off management.
What may change Kaye’s mind is if she plans on making additional investments with this Self Directed IRA. In that case the monthly transactions may grow in number and Checkbook Control would be more economical. The setup fee is higher but it is quickly compensated for by possessing unlimited free transactions. Additionally multiple transactions are more easily handled via a checkbook then they are by going through a middleman custodian.
How Does a Self Directed IRA Invest in a Private Promissory Note?
Once your Self Directed IRA is setup, there is a simple 3-step process for making a loan with a promissory note.
- Title is established in the name of your IRA (e.g. “Madison Trust Company Custodian FBO [Your Name][MTC Account #]”).
- You request Madison to send the requested loan amount to the borrower.
- The borrower makes loan payments directly to your Self Directed IRA account.
The documentation you need includes an Investment Authorization form, the promissory note itself, and a security document like a Deed of Trust. When the note has been repaid, you will submit a Satisfaction of Note form.
For more detailed instructions on investing in a promissory note, please visit our instructions page here.
How Can a Self Directed IRA Investigate a Promissory Note Offering?
In addition to private loans, a Self Directed IRA can also purchase company sponsored promissory notes. This kind of investment requires a tremendous amount of due diligence. There are some legitimate promissory note offerings, but most of them will be limited to top level accredited investors. If you would like to purchase a commercial promissory note, due your due diligence and find out the answers to the following questions.
- Why am I being offered this investment? – Most Self Directed IRA investors are not the normal recipients for high level promissory note offerings. Even if the offering is coming via somebody you know and trust (e.g. a local insurance agent,) don’t let their assurances convince you to purchase. Investigate the company behind the offering, what kind of commission they are offering to the middleman to push the investment, and their track record with previous offerings.
- Why is the company not getting a bank loan? – Chances are because they can’t. Find out why the company was rejected and what led them to approach individual investors.
- Is the promissory note registered? – Most commercial promissory notes qualify as securities and by law must be registered with the SEC. This is good for your Self Directed IRA as the SEC does some kind of preliminary due diligence. If the note that you’re being offered is not registered, that may be a major red flag.
- Were you promised a great level of security and a really great interest rate? – Let’s just suffice it to say that if a deal sounds too good to be true, it probably is. This is especially true for your Self Directed IRA funds.
- How does the company plan on paying you back? – This may sound like an obvious question, but sometimes the most obvious scams are the ones that fly beneath the radar. If the company doesn’t have a solid business plan or if you find that a very high percentage is going towards marketing and promotion, then it’s time to have your Self Directed IRA look elsewhere.
Here are online sources that can help you research these kinds of offerings.
- The SEC EDGAR database – Here you can find companies, offerings, and various reports. If the offering is not listed here, it means greater due diligence is necessary.
- North American Securities Administrators Association – This site can provide you information if the company and offering are registered by your state.
- FINRA BrokerCheck – This can help you research the background of specific brokers and firms.