One of the advantages--also, in fact, a potential disadvantage--of a self-directed IRA is that there are a plethora of investment opportunities to choose from. Today we are specifically going to look at private loans. Private loans are loans made from an individual to another, so no banks are involved. In terms of private loans as an investment vehicle, there are, of course, pros and cons.
Private loans can potentially provide investors with substantial returns. Typically, borrowers turn to private loans--knowing they are going to be more expensive than traditional bank loans--because they can’t qualify or don’t have time to wait for bank loans. Again, this can present both a risk and an opportunity for investors. In addition, private loans can also be secured against assets--including most notably including real estate--helping to minimize risk factors.
Investors considering private loans need to take several factors into account. First off, they need to make sure to judge the adherent risk involved with the particular loan accurately. There is a reason these borrowers are turning to private lenders for money, and investors need to find the balance between risk and return. Secondly, banks make their money by lending money; they have the process and paperwork down to a science. They know exactly what they need to do and what they need to have the borrower sign in order to ensure that they have maximum protection under the law. As a private investor you would be wise to do the same. Make sure your contract is good and that you are taking all necessary steps to validate the contract. If it needs to be recorded at the court house, make sure that gets done, and so on. Lastly, private investors need to understand what to do if the borrower defaults. What process do they need to follow in order to collect? With private loans made to friends or family this part becomes especially hard to swallow, but if investors are truly looking out for their investment, they need to take appropriate action.
Now let’s look at some of the things self-directed IRA investors need to keep in mind when investing in private loans. One of the biggest factors that self-directed IRA investors need to understand is the prohibited party rule. When investing your self-directed IRA funds, there are certain people with whom you are not allowed to deal. According to the IRS the following people are all disqualified:
- The IRA owner; his or her ancestors (i.e. parents, grandparents); his or her lineal descendents (i.e. children or grandchildren)
- The spouse of the IRA owner
- Financial advisors and other fiduciaries
- Any entity owned 50% or more by a disqualified party (such as a business half-owned or more by the IRA holder’s daughter)
If you deal with any of these people, you are going to be in direct violation of the rules and will be heavily penalized. Outside those mentioned above, you are able to deal with who you wish, however remember this next point: As the person in charge of your IRA’s investments, you have a fiduciary responsibility to the IRA. That means that if you decide you want to lend money to your brother, girlfriend or anyone else with whom you have a relationship, you are required to put the best interest of the IRA ahead of your relationship. If your sister defaults and you don’t send her to collections, the IRS could find that you’ve violated your responsibilities and still hit you with all the penalties. This is not a situation you should take lightly, so as a self-directed IRA lender, you need to make sure that if you lend money to someone you have a relationship with, you are willing to do what is necessary to act in the best interest of your IRA. Make sure they understand this upfront, too, so that if push comes to shove, the will be prepared.
Another thing to keep in mind when investing in private loans with your self-directed IRA is that loans are not always liquid. Make sure you are aware of the mandatory distribution rules (required distributions start at age 70.5) as well as when you might need to access those funds for retirement expenses.
With that in mind, if you take the appropriate precautions, private loans can be a great investment for their IRA. Personally, if I were making private loans in my IRA, I would limit them to secured loans (preferably real estate) at fairly low LTVs. I want to know that the money in my IRA is safe and secure, but I also want to see it grow. Done correctly, private lending can achieve both those goals. Compared to what is going on in the stock market and real estate markets right now, making private loans seems like a pretty good option. If you are making real estate loans right now, though, make sure the LTV is low enough to account for possible value loss.
One telling sign as to the validity of private loans within self-directed IRAs can be found in a client survey done by Guidant Financial Group recently, in this survey they found that private lending within self-directed IRAs had increased 131 percent since 2005. That’s a huge increase in self-directed IRA private loan activity, and in today’s market I certainly can’t say I blame them.