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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.
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Many
investors have invested in “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.
Investing in real estate for
your retirement may serve as
a means to diversify your retirement
portfolio to hedge against the
cyclical changes in the stock
market, economy and bank and
government-based investments.
For many who are experienced
with real estate investing, real
estate investments hold the potential
to protect against the loss of
principal while generating better
than market rate returns through
income production and capital
gains. When real estate investments
are not leveraged, both income
and capital gains can flow back
to IRAs tax-deferred (or tax-free
if the IRA is a Roth IRA). |
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