How a Private Mortgage Works in a Self-Directed IRA or Solo 401(k)

Private lending for real estate is an investment strategy that allows your self-directed IRA or solo 401(k) to earn income on the interest payments and other terms of the loan. Income from a private mortgage enjoys the tax-advantaged status of a retirement plan asset, provides critical diversity, and creates additional capital for you to reinvest.

The primary focus of this article is how a private mortgage for a home works in a self-directed retirement plan, but this information is also helpful for those who use their personal investment funds as loans.

You’ll learn how a private mortgage works, different loan structures, the basics of the terms (interest rates and repayment schedule), as well as exit strategies in case the borrower defaults.

What Is a Private Mortgage?

Private lending for real estate is not a new concept. This investment strategy includes private mortgages for homes, funds for a down payment for homes, and loans to purchase other types of real estate like unimproved land, commercial and multifamily properties, and rentals and rehabs.

But when interest rates are high, a private mortgage can provide individuals with an alternate way to acquire funding for new homes without having to jump through the more stringent hoops of conventional mortgage requirements. Smart investors see the opportunity here—a way to earn income by helping these borrowers out.

Most people are familiar with conventional mortgage notes—transactions between individuals and conventional lending institutions like banks or mortgage companies. But private lending is different.

As the word “private” indicates, this type of lending takes place between an unconventional lender like a friend or an investor who loans the borrower money for the purchase of a home. The terms of private mortgage notes are structured the same way as their conventional mortgage loan counterparts. The interest rate, payment schedule and amount, late fees, length of the loan, etc., are agreed upon between the private lender and the borrower. Legal contracts and promissory notes are signed that solidify the terms of the loan.

You can also structure private mortgage interest rates the same way banks and mortgage companies do:

    • Fixed interest rate
    • Adjustable rate
    • Graduate payment
    • Balloon payment
    • Interest-only loan

Additionally, just like a conventional home loan, a private mortgage loans is secured by collateral, which is typically the home or real estate the borrower purchases with the loan funds.

How Your IRA Can be the Bank in Private Mortgage Investments

When your self-directed IRA or solo 401(k) loans funds as investments, it becomes the bank in the loan process. You do not take a distribution of funds to extend the loan, otherwise you’d owe taxes and possibly an early-distribution penalty. The loan itself is an asset of your retirement plan. Loan funds are distributed from your IRA directly to the borrower, and the private mortgage note is titled in the name of your IRA. This protects the tax-sheltered status of your retirement savings as well as future earnings from the loan.

Here’s how it works:

    • Your retirement plan owns the note as an asset, and all paperwork reflects the IRA as the owner of the private mortgage note.
    • As the self-directed retirement plan owner, you vet each borrower.A man and woman sitting at a table with their young daughter wrapping up a private mortgage investment deal with their private lender.
    • You and the borrower agree upon and set the terms of the loan.
    • The home the borrower purchases is assigned as collateral.
    • Loan funds are distributed from your retirement plan to the borrower.
    • Loan payments are assigned to and deposited directly into your IRA or solo 401(k).
    • Your plan earns income on the interest and other terms of the loan.
    • Income from the loan enjoys tax-sheltered growth within your retirement plan.

Two Additional Private Lending for Real Estate Opportunities

1. Mortgage down-payments

Often, home buyers may be approved for a mortgage by a bank but lack funds for the down payment. In the average scenario, this may be a friend or relative that you feel comfortable dealing with. Your IRA can lend the funds and you can choose to make this note unsecured without collateral, if you wish, or stand in line behind the bank as a second lien holder on the property.

2. Loan funds to a real estate investor

It is not uncommon for investors to use other people’s money (OPM) to invest. In fact, it’s quite popular. Here again, you and the borrower set the terms of the loan depending on what type of real estate the borrower is eyeing.

3. Provide loans for other uses

You may know other individuals who are looking for personal loans, cash to purchase an automobile, recreational vehicle, or anything else. Or perhaps you know people who are involved in investing clubs or are seeking start-up capital for a business venture. Your IRA can play the part a bank would here, too, and loan funds to an individual or an entity that needs capital for any endeavor.

Remember, just as with a private mortgage loan, you’re responsible for performing all due diligence to fully evaluate any other lending opportunity for your self-directed retirement plan. You have the freedom to be as picky and choosy as you please and can set your terms as strictly as you wish.

What Happens if the Borrower Defaults on a Private Mortgage?

If the borrower defaults on a private mortgage, your retirement plan takes ownership of the house. You have a few choices here that can help you recoup the balance of the loan.

You can sell it and possibly earn additional profit depending on the sales price. Income from a sale is deposited into your retirement plan on a tax-sheltered basis.

You can use it as a rental property and continue earning monthly, tax-sheltered income from rent payments. Depending on the remaining balance of the initial private mortgage, this option would probably be a long-term investment, involve expenses to maintain the property, and may not be a feasible option.

When considering private loans that are not backed by collateral, you have no immediate recourse to recoup the balance.

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How to Get Started Investing in Private Mortgages and Notes

Advanta IRA is a nationwide leader in self-directed IRA services with over $4.5 billion in assets under management. Our clients use self-directed Roth IRAs and traditional IRAs, SEP and SIMPLE IRAs, solo 401(k)s, and even self-directed health savings accounts and education savings accounts to build wealth using alternative investments to the stock market.

We make it easy for you to roll over an existing IRA or old 401(k) funds into a self-directed plan that fits your needs. Our client account managers lead you every step of the way, throughout each investment process. Advanta IRA takes care of administrative recordkeeping tasks pertinent to your account so you can focus on identifying promising investments for your account.

If you have questions about how your IRA can be the bank in private mortgage transactions or wish to learn more about self-direction, please contact Advanta IRA today.

Additional self-directed IRA resources:

7 Benefits of Self-Directed Solo 401(k) Plans for Small Business Owners

10 FAQs about a Self-Directed IRA (SDIRA) + Alternative Investments

10 Ways to Find Investment Alternatives to the Stock Market for Your IRA


About Scott Maurer

Scott Maurer, Vice President of Sales for Advanta IRA, is a recognized expert in the field of self-directed IRAs. With a law degree from the University of Florida and as a designated Certified IRA Services Professional (CISP), Scott’s keen understanding of rules and regulations fuels his passion to educate others on the power of investing in alternative assets using self-directed IRAs. Scott is a frequent guest on retirement and investing webinars and podcasts, and he has shown thousands of individuals how to achieve financial freedom by teaching them how to use their retirement funds to invest in private placements, real estate, private lending, and more. Throughout his two decades in the industry, he has watched numerous unique investments unfold, giving him great perspective of what is possible when people take control of their retirement funds and investing decisions.