IRA Financial’s Adam Bergman Esq. discusses short-term hard money loans, which are becoming more popular because of low interest rates and the looming possibility of inflation.
The best benefit of self-directing your IRA is the ability to make nontraditional, or alternative, investments. Real estate, precious metals, businesses and, most recently, cryptocurrency, are the most popular. However, many people don’t know that they can loan money from their IRA. During these crazy times, investors have lots of cash on hand, since they can’t do much with it right now, like traveling, going to shows and eating out. You can use the cash you have sitting in your IRA and loan it out and get a decent rate of return, while helping someone in need.
Why Are Hard Money Loans Increasing in Popularity?
There are two reasons why hard money loans are becoming more popular. First, interest rates have fallen to near zero percent. Secondly, the risk of inflation in the near-future is very real. Lending money now at low interest rates, while the dollar still has power, makes sense for many investors. Specifically, hard money loans are great for real estate investors.
Now, we are not talking about 20-30 year loans. These are short-term loans that are generally, for a year or two. At max, they should only go as long as five years. You don’t want to wait too long to get the money (plus interest) back into the plan. In fact, real estate developers or construction companies might need a loan for only a few months.
Banks might be reluctant to offer some investors a short-term loan. This is where you come in. If your money is just sitting there and not earning much, you can set a decent interest rate, to improve on the return you are (or are not) getting right now. Obviously, loans are not without risk, so you must be sure you are lending to the right people.
How Does a Loan Work with an IRA?
First, your plan must allow for alternative investments. This is why you will need a Self-Directed IRA. When you self-direct, you are in control of the investments you make, not the IRA custodian. Next, you must be aware of the prohibited transaction rules.
They state that you cannot directly or indirectly benefit from an IRA investment. Only the IRA may benefit from it. Therefore, you cannot loan money to yourself (the IRA owner), your spouse, or any lineal ascendant or descendant, their spouse or entities controlled by them. These include parents, grandparents, children and grandchildren. For example, you cannot loan money to your father for a rental property. However, you can give a hard money loan to your sibling, uncle or best friend.
It’s important that you do not lend to a business that a disqualified person is involved with, especially small businesses. You risk violating the prohibited transaction rules if your IRA is not considered the sole beneficiary of the investment. In the podcast, Mr. Bergman talks about a court case that violated these rules.
Of course, the first thing to keep in mind is who the borrower is. Do your due diligence to make sure they will pay back the loan. You then need to decide if they will personally guarantee the loan or not. If they do not, you can certainly charge a higher rate or get a stake in the investment.
This is not a bank loan, so it’s up to you and the borrower to agree to the terms of the loan. If you are close with the borrower, it cannot be a gift, so you should charge at lease the prime rate for the loan. On the other hand, be aware of state usury laws, or loan-sharking, by charging 100% interest, for example.
Since these loans are short-term, inflation should not be a concern right now. When interest rates go up, you can make a new loan at new terms, to ensure you are making the most of the investment. Obviously, the point of using a Self-Directed IRA for a hard money loan is to generate a nice rate of return. Only make a loan if your money will work harder than it is earning right now. A ten percent rate of return on a loan is way better than three percent you might be getting right now in low-risk investments.
As Mr. Bergman explains, hard money loans are not without risk. The level of risk you take should reflect the returns you receive. The most important thing to remember is not to break the prohibited transaction rules. The IRS will look into you if you try to take advantage of the rules and personally benefit from the loan/investment.
Feel free to reach out to us if you have any questions about the hard money loan. Lastly, it’s important that you work with a financial planner to ensure you are making smart investment decisions. IRA Financial, including Adam Bergman, does not provide advice, but simply shares ways to use retirement funds. It’s up to you to decide what fits your goals and risk tolerance!
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