 |
Overview
A note is an extension of credit from one or more individuals
or entities (lender(s)) to another individual(s)or entity(ies)(borrowers).
An IRA is able to extend credit to any party (including corporations)
as long as the party is not considered a “disqualified person”.
Such notes can be either secured or unsecured. If they are secured,
it means that in the event the borrower defaults on the loan from
the lender, the borrower agrees to supply the lender with the “collateral”
or “security” in lieu of the principal balance of the loan.
The most common example of a secured loan is the mortgage you may
have on your primary residence. In this case, you get a loan from
your bank, after supplying an agreed upon amount of equity or down
payment. The bank will extend the loan only if you pledge the deed
to your property as “collateral”. Thus, if you fail to make your
mortgage payments to them, they have the right to “foreclose” and
take the property from you. And to make matters worse, you will
lose your equity or the amount you originally invested and any appreciation
since buying the property.
In many states, these loans are called mortgages. In some states,
they are called “”trust deeds” or “deeds of trust”. In any case,
they are secured loans (notes), usually with property as collateral.
The collateral can be real estate (of any kind), gems, mineral rights,
a car, plane or virtually anything else of value as agreed upon
between the borrower and lender.
Many of PENSCO Trust’s clients have invested in nothing more than
such “trust deeds” over the years, and have experienced steady returns
in the range of 9-15%, depending upon market conditions and the
creditworthiness of the borrower(s). These investments generally
result in monthly income (principal and/or interest payments against
the loan), which makes them suitable for someone who requires a
steady income (distribution) from their IRA. One of the keys to
the success of these investments is the quality of the “underwriting”.
This entails, briefly, evaluating the creditworthiness of the borrower,
and the value and the condition of the property itself (so that
the lender or IRA owner can be assured in the event of default,
that his or her IRA will be able to receive at least the amount
of his or her investment in the event of foreclosure). If the note
is secured by a deed (hence “trust deed”) to a property with a low
loan to value (e.g., amount of debt/value of property), there is
a good chance, if a default occurs, that the lender will not only
get their entire investment back, but also a good part of the equity
buildup, including the borrower’s down payment.
However, the objective of most of these loans (sometimes referred
to as “hard-money loans” because of their generally higher rates
of interest) is not to have the borrower default. Most of these
loans are given to people in the midst of some financial crisis,
such as the loss of their job, or a medical crisis, where they need
short time financing that would otherwise not be available through
traditional lenders such as banks. Banks, who are not in the business
of foreclosing and taking physical possession of properties when
their debtors default, will generally require a borrower to have
a regular source of income before they will lend to him or her.
Hard money lenders, who specialize in these so-called “B” or “C”
paper loans, will usually not lend more than 70% of the value of
the property, to be sure that their risk of loss is mitigated. In
addition, the more equity a borrower has in their property, the
more likely they will do everything they can to ensure that they
don’t go into default, thus, losing their equity investment in the
property. The balance between the needs of the supplier (lender),
and the demander (borrower), is usually determined by a mortgage
broker that specializes in “hard-money loans”. The broker generally
finds borrowers and then “brokers” or sells the loans to investors
(the lenders, including self-directed IRAs). The broker charges
1-2% and the balance of the yield on the loan goes to the investor.
Most of these brokers also offer to “service” these loans, for an
additional fee, which can range from $10/month to .5-1% of the loan
value per year. Servicing means collecting the loan payments and
processing them, as well as going after delinquent borrowers. Some
states will have licensing and regulatory requirements for such
firms. California, for example, one of the top hard-money mortgage
lending states, has supervision over all such “hard-money” lending
firms through its Department of Real Estate. It is important to
understand the rules in your state regarding these type of loans
and the brokers who provide them, to be sure that you enter into
a sound and legal investment. But, done correctly, with good underwriting,
these loans can be a good source of consistent and above-market-rate
returns. Of course, when these compound tax-deferred in an IRA over
many years, the results can be dramatic.
|
