Investing in real estate notes is one of the most popular self-directed IRA investments. With that popularity come common mistakes when people lend their IRA (and non-IRA) money secured by liens on real estate. Follow these ten tips to avoid potentially costly errors.
Decide whether to make the loan at all
1. Never lend on something you wouldn’t want your IRA to own
If your borrower defaults, you may end up owning the property. The risk of these loans is matched by the reward: I routinely see yields of 12% and higher. But borrowers can default, and you may be left with the property in foreclosure. If the thought of taking over the property would upset you, you probably should not make the loan.
2. Don’t lend to someone you’d be 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 disagree, because lending and borrowing drive our economy and increase economic activity.
But 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.
3. If you’re unsure how to evaluate the loan, hire a professional
A hallmark of the self-directed IRA is that you make your own decisions and find your own investments. Yet most IRA owners lack either the knowledge or, in my case, the time to evaluate a loan properly.
My solution is to hire a professional to help 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. He charges a fee, which is passed through to the borrower on top of any interest and fees my retirement plan charges. That raises the cost of the loan, but here the non-Biblical golden rule applies: “He who has the gold makes the rules.”
Structure the loan to protect your IRA
4. Don’t advance money for repairs until the work is done and inspected
This is one of the biggest mistakes I see clients make with their IRAs. They fund the full loan amount expecting the repairs to be done, but the borrower ends up needing a little more money for another project. If the loan goes bad, the IRA could be stuck with a property that never got the necessary repairs.
5. Collect interest monthly
Many borrowers, especially investors, would rather pay interest at the end of the loan. That exposes the lender to extra risk. Collecting payments monthly does two things:
- It reminds the borrower that he or she has to do something with the property to avoid the pain of the payment.
- It tells you when the borrower is in trouble, because payments start getting missed.
Keep in mind that unless the loan calls for monthly payments, you may not be able to foreclose even when you learn the borrower is in financial trouble, because the loan may not be in default. This has actually happened to some of my clients.
6. Get a personal guarantee from an entity or a weak borrower
When things are going well, you may be tempted to skip the personal guarantee, and many borrowers will resist giving one. But circumstances change, and a guarantee can help you collect.
I once collected on a note where the property had lost much of its value to vandalism and market conditions. Instead of foreclosing, I had my lawyer write to the guarantor, who had significant assets. The letter explained that he was personally liable on the debt and that if the note wasn’t satisfied, I would take legal action against him and the borrower. A week later, a cashier’s check arrived that paid off the lien.
Protect the collateral
7. Get title insurance for the loan
Title insurance shifts risk away from you and onto the title company. In Texas, where my office is, the extra cost of a lender’s policy is very small when it’s issued along with an owner’s title policy. Whatever the cost, protecting your IRA from title flaws is important.
8. Make sure hazard and flood insurance name your IRA
Verify that hazard insurance and, if needed, flood insurance are in place with your IRA named as an additional insured. This is easy to miss in the rush before a closing. Borrowers may get insurance at the last minute and simply forget to add your IRA. If something goes wrong, you want your IRA’s name on the check.
9. Require proof that taxes and HOA fees are paid
Insist that the borrower show you evidence of payment when property taxes and homeowners association fees come due. The same goes for hazard and flood insurance premiums, although you would normally get a cancellation notice if those went unpaid. Depending on where you live, unpaid property taxes can grow quickly with penalties and court costs, eating into your equity position.
Act fast when a loan goes bad
10. If the loan goes into default, take action immediately
No one wants to admit a mistake in self-directed investing, but delay can be costly. You can always stop the foreclosure process once it has begun, but you can’t finish it unless you start it.
Other things to understand before you lend
This list is not meant to be complete. You will also need to understand:
- 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 your state’s foreclosure process, in case the loan goes into default
Always get good legal counsel to help with the loan documents. Since the borrower traditionally pays all expenses, including legal fees, there is no reason not to have an attorney draw them up.
Lending can be an excellent IRA investment. It is relatively easy, and done correctly it carries comparatively low risk. Getting to know the successful real estate entrepreneurs who borrow your IRA money can bring other, intangible benefits as well.
