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Module 10 · Retirement & Wealth

Neither a Lender nor a Borrower Be: Private Money Lending Out of Your IRA

How a self-directed IRA can make hard money loans, why short-term private money can cost borrowers less, and how to avoid usury.

8 min read · Lesson 10.6

Personally, I think Shakespeare had it wrong when he wrote 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 can be forgiven, since Shakespeare never enjoyed the tremendous benefits of a truly self-directed IRA.

Money in a self-directed IRA can be loaned to any person who is not a “disqualified person.” You cannot lend to yourself or to other disqualified persons related to you, but you can lend to anyone else.

Loans can be secured by real estate, mobile homes, equipment or anything you like. If you are a really trusting soul, you can even make an unsecured loan from your IRA (although in that case I would tend to side with Shakespeare).

Borrowing from other people’s IRAs

First, look at it from the borrower’s side. One way to make money for yourself right now with your knowledge of self-directed IRAs is to create your own “private bank.” Simply share the news that an IRA can be a private lender, refer people with IRA money to a self-directed IRA custodian, and then borrow their IRA money for your own financing needs.

With private financing, the loan terms can be whatever the borrower and lender agree to, within legal limits. If you know someone earning 5% in a “safe” IRA at a bank, and you can offer 9% secured by a first lien on real estate at only 70% loan-to-value, would they be happy with that?

Even at a higher interest rate, private financing can work for you. IRA loans can be done quickly and without a lot of fees or fuss. That may let you win a deal you would lose waiting on a bank, especially in distressed sales such as pre-foreclosure purchases.

What your IRA earns as a hard money lender

From the lender’s side, 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 the custodian’s fees and any legal fees for preparing the loan documents.

True, you won’t hit a home run with lending unless you’re fortunate enough to foreclose on the collateral. But the returns can be quite solid. By making very conservative hard money loans, my mom’s IRA grew by about 10.5% in one year. That’s much better than she was earning in her money market fund before she moved to a self-directed IRA.

Even small IRAs can join 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 five other IRAs to make one loan. The smallest IRA in the loan held just $1,827. Each account earned 2% up front and 12% interest on an 18-month loan, secured by a first lien on real estate at no more than 70% loan-to-value.

Steer clear of usury

One thing to avoid in hard money lending is usury: contracting for or receiving interest above the legal limit. The usury limit varies from state to state, and a few states have no usury limit at all on commercial loans.

Some people take the attitude “What’s a little usury among friends?” But if the investment goes bad and your IRA has made a usurious loan, a borrower’s usury claim could cost you all the principal of the loan plus damages equal to three times the interest. Some states even have criminal usury statutes. Consult a competent attorney before making a hard money loan to make sure your IRA doesn’t violate any usury laws.

Worked example: a six-week rehab loan

One of our clients made a hard money loan from his IRA to an investor who bought a property needing rehab. The loan covered the purchase price plus the estimated rehab costs. The investor had the slab repaired, and before he could take the next step, someone offered him a fair price for the property as is. He accepted, and they closed about six weeks after the loan was made.

TermDetail
Interest rate15%, no points or other fees
Minimum interest3 months (3.75%)
Other loan cost$300 attorney’s fee for the loan documents
Time the money was outAbout 6 weeks
Investor’s profit at closing$20,000, with no money out of pocket
IRA’s annualized returnAbout 30%

Three months’ interest for six weeks’ use: about 30% a year.

Why short-term private money can cost less

Was this a good deal for the investor? It certainly was. He paid a relatively high rate for the time he borrowed the money. But he bought a property with substantial equity that a bank most likely would not have financed because of its condition.

And while the rate was high, the cost of the financing was actually low. A bank or mortgage company charges origination fees, discount points, processing fees, underwriting fees, appraisal fees and other expenses. On the surface the rate may be 8%, but the real cost is higher once you add the lender’s fees. Spread over a long loan term, those fees don’t add much. Pay them all up front and pay the loan off in six weeks, and the cost of the financing goes way up.

Here, the investor’s total loan cost was three months’ minimum interest plus $300 in attorney’s fees. Best of all, he walked away from closing with $20,000 profit and no money out of his pocket. Far from “dulling the edge of husbandry,” this loan made the husbandry (the purchase and resale of the property) possible. The buyer was thrilled too, getting the property below full market value so they could fix it up the way they wanted.

The lender was also happy. His IRA received three months of interest at 15% while the money was out for only six weeks, a rate of roughly 30% a year. Although that yield was above the legal limit for interest in Texas on loans secured by real estate, prepayment penalties are generally not included in the usury calculation there, so there was no problem. The investor, the new homeowner and the lender all came out ahead.

The worst case: the borrower pays you back

When I lecture on hard money lending, I ask the audience what the worst thing is that can happen to a hard money lender. Most people answer that you have to foreclose. Nonsense! If you are lending correctly, the worst thing that can happen is that the borrower pays you back. Unfortunately, that is a common risk.

Most hard money loans are made at 70% or less of the property’s fair market value. If you do foreclose, your IRA acquires a property with substantial equity, and the investor did all the work of finding and rehabbing it.

It’s true that foreclosing on a friend’s property may end the friendship. But a properly secured loan will not “lose itself,” as Shakespeare warned, and it may lead to a substantial profit for your IRA. To avoid losing a friend, simply don’t lend IRA money to anyone you would feel bad foreclosing on. To be a successful hard money lender, you have to be prepared to foreclose if necessary.

In modern times, the better advice, at least in the right circumstances, is “Either a lender or a borrower be!” Borrowing OPI (other people’s IRAs) can lower your total cost of financing compared with a conventional loan, especially for short terms. And as a lender, your IRA can earn solid returns with little time and energy on your part.

Key takeaways

  • IRAs can lend to non-disqualified persons
  • Short loans favor low-fee private money
  • Lend at 70% loan-to-value or less
  • Check state usury laws first
  • Only lend where you’d foreclose

Try it yourself

A loan charges 15% interest with a 3-month minimum. What does the minimum interest come to as a percentage of the loan?

Show answer

3.75%. Fifteen percent a year divided by 12 months is 1.25% a month, times 3 months.

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