Natali Morris Blog

August 16, 2016

How To Make Money By Lending Money

My IRA is set to make 6% interest for the next 10 years. How do I know this? Because I recently lent that money to a family friend to make his own investment and those were our terms.

A few weeks ago, I wrote about using a self-directed retirement account to invest in whatever the heck you want. I used my self-directed Roth IRA in the case of this note. A friend had found an investment property that cost $35,000. He had $15,000 of his own money and needed to borrow the remaining $20,000. We set the terms to our mutual agreement in a private note.

In this post I want to discuss why anyone would engage in this kind of private financing. But first let me be clear: you can lend money to anyone you want with pretty much any money you’ve got. You can use some extra cash that you’re not sure what to do with. You can use a self-directed retirement account. You can even use a self-directed 401(k) if your employer allows these types of funds. (Unfortunately many do not.)

The point is that if you find a bucket of money that you’d like to lend to a trustworthy investor, consider this! Especially consider this if you are extremely uncomfortable with the stock market – a sentiment I share in this volatile global economy!

Why lend private money?

I don’t want to trash talk the stock market but there are a lot of drawbacks to this form of investing. My biggest issue with the stock market is that it is an investment that I cannot effect. I can only make educated decisions about which companies will perform and then hope that capable people will make it happen.

I also know that stock investing is cyclical. The market takes a dive every 10 years and some experts anticipate that will soon start to happen every 5 years. I know that overall the stock market makes money over long periods of time but I don’t like riding this slow wave. I like to take a more active approach to my money.

When you structure a private note, you are in charge of the terms. You can say how much you want in interest and how long you want to lend. I am comfortable with some of my money in stock accounts such as our 529s and 401(k)s. But for a Roth IRA that I want to grow slowly but surely as I inch towards retirement, I would like to set a steady growth rate. A 6% return for 10 years is something I am very comfortable with.

Let’s look at the numbers on that $20,000 loan: A 6% amortized loan over 10 years turns that $20,000 into $26,644.92. That is a solid performance for that “later money” investment! Also consider that because this is a Roth account, it is tax-free growth!

Is it a good rate for money for the borrower? Let’s examine.

Why borrow private money?

Could this investor do better with a bank loan at around 3 or 4%? Maybe. But consider this: banks don’t like to lend money on investment real estate. If they do, they will only do one rental property – MAYBE two. Which is nice but you’re not going to build a retirement portfolio on one or two rental properties. If you want to build a rental portfolio, you have to start exploring several options.

And what about investing inside of your LLC or small business? Banks don’t play that game. They will not lend to your corporate entity. They will only lend to you, the private person. This is not a good way to own investment property. Listen to this podcast that my husband and I did with tax expert Tom Wheelwright for more on that.

So say this investor has an investment that they know will perform at between 8 and 12% return. Wouldn’t it make sense to secure a private loan at 6% and still cash flow on that deal? Especially given that this deal will be theirs outright in 10 years and then the entire 8-12% will be theirs to keep?

Could they shop around for a lower rate than 6%? Maybe. They are free to try. That is the beauty of private notes: they don’t happen until both parties agree to terms to their liking.

What about the personal relationship?

What if my friend decides to stop paying on this note? What if the investment starts to lose money and they can’t pay? What if they offend me in some other way and I don’t want to have any relationship with them ever again?

Valid questions! You have to be secure in your relationship with this person. I don’t think this is as tricky as Dave Ramsey thinks it is. Are you a nervy and untrustworthy person? Is your friend? Then don’t do this kind of thing.

My dad likes to say that there are about 5 people that he would trust with $1 million for a year. I think that is a good litmus test. Would you trust this person to hold your money safe and not touch it? Would you do the same for them? You know yourself and you know your friends and family. Loan accordingly.

As for my relationship with the person we lent to, I do trust this person implicitly. It is a person with intelligence, conscience, and dignity. This loan has not put our friendship at a power imbalance at all. This is something we are both comfortable with. It takes some sincere personal questioning but if you are willing to do this, see the above benefits to doing so!

Also note, this is not me writing a personal check to a cousin hoping that cousin will pay me back. I am formalizing this process while also trying to keep it simple. It is a delicate balance!

How do you structure a note?

This I leave to an expert. I have a title guy who does this for me. You can create something yourself on LegalZoom if you’re comfortable with it but my guy charges me less than $150 and that is an expense I am more than comfortable with.

The gist of the note is this: Person X agrees to borrow $$ from Person Y for a certain number of years at a certain interest rate. Add some legal talk about late fees, penalties, escape clauses, etc.

In the case of a real estate deal, this note gets filed with the closing documents.

How do you get paid back?

In the case of my loan, my self-directed IRA company requires payments come with a payment coupon with my name and account number. I printed out a stack of these coupons for each month and sent them to the borrower. He has not missed a payment since the loan started 6 months ago.

If you don’t want to do this, have a loan servicing company help you. They don’t cost very much and they help guarantee that your money will trickle back to you as promised.

What if???

What if the investment goes south? What if the borrower can’t pay you back? Here is where the communication inside the relationship is key. Let’s say the rental market takes a dive and my friend can no longer afford to pay 6%. Let’s say this investment is now only netting him 6%. Would I prefer to renegotiate the terms for 4% so that I keep getting paid back and my friend can still make some money? You bet your socks I would! I would totally be open to this! And I can do whatever I want with this note because it is between me and a friend.

The point is for my borrower to keep me up on the progress of the investment and the note and for me to be open minded about it. If the above scenario happened five years into the deal, I would have already made a great return for five years and would be far more amenable to knowing my options in advance rather than my borrower getting into trouble and then stop paying altogether. This is the beauty of not being a bank or borrowing from a bank: we can do whatever the heck we want as long as we can come to reasonable agreements of what is fair.

Shouldn’t you just make this real estate investment yourself?

Well I could and I have comparable investments in my own portfolio. But the name of the game is diversification! We own some investment property, we own some aggressive stock-based funds in our 401(k) and 529s, and we have some conservative notes in our IRAs. We don’t need ALL of our money in investment real estate, although my husband would have it that way if he had his druthers.

I love this idea! Where can I learn more?

I learned a lot of this from an awesome book called Getting The Money by Susan Lassiter-Lyons. She teaches real estate investors to invest with private money and she is genius!

I am not saying this is for everyone. I know plenty of people I wouldn’t trust with a private note if the Dahlai Lama himself set the terms and executed the deal. But like all things finance, shouldn’t you at least consider it??

Comments welcome below! Unless you are quoting Dave Ramsey and his philosophy on lending to friends. In which case, I’ve read the book and I have my own philosophy. Re-read all of the above.


2 responses to “How To Make Money By Lending Money”

  1. Nate says:

    Lending money from an IRA is a very under-appreciated wealth-building strategy. Thanks for making a post about it! I encourage everyone who wants to explore this strategy to do as Natali did and formalize the loan with a promissory note. Keeping good records is important, because you’ll want to be able to prove to the IRS that the loan principal (and its repayment) aren’t gifts or anything like that. In an extreme event, your whole loan amount (not just the interest) could end up subject to taxation. Formalizing the loan with a contract also helps prevent mismatched expectations and other problems down the road. If the other party isn’t willing to put it in writing, don’t do it!

    Toward the beginning of this post, you say: “you can lend money to anyone you want with pretty much any money you’ve got.”

    Be really, really, really careful with self-directed IRAs. It’s easy to slip up if you aren’t intimately familiar with the rules and get your IRA (or some portion of it) disqualified by the IRS. That means taxes and penalties, and no more tax-free compounding. Personal loans using IRAs are NOT ALLOWED to or from immediate family members (husbands, wives, children, parents). This is considered “self-dealing” and if the IRS catches you it will mean big trouble. Depending on your situation, there also may be limitations on making loans to entities (e.g., an LLC), because you usually have to be an accredited investor (read: millionaire) to loan money to a business. You may be able to lend money to an entity if you work for the company or are an owner, but that would probably still not be allowed in an IRA because of the rules against self-dealing. Definitely do your research and ask a lawyer first.

    Also, keep in mind that personal loans cannot be interest-free (not that you’d necessarily want to do that anyway if your goal is to make the loan as an investment). Below what the IRS considers the “market rate” (usually 1-2%), they’ll see any interest you don’t charge as a gift, and subject to annual gift limits and taxes.

    Finally, look into your state’s usury laws (if applicable). Some states have surprisingly low limits, and these limits can vary depending on the size of the loan. If things turn sour with the borrower, a court could throw out the note (meaning the lender loses 100% of their money) and even award damages in excess of the principal (I’ve read about *triple* damages in some cases). These laws are in place to prevent loan sharking, and most people who make the kinds of loans you describe in this post will never come close to their state’s limit, but it’s good to check first. Better safe than sorry.

    NB: I’m not a financial advisor, accountant, or attorney. Consult an expert and do your own thinking.

    • Oh I learned something new from this comment, Nate. Thank you! I had no idea that you have to loan at market rate or else be subject to a gift tax. Interesting. These are great points. Thank you for your input!

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