What Happens if a Borrower Defaults on a Promissory Note?
When a self-directed IRA invests in a promissory note, there are a variety of associated risks uncommon to other types of investments. By planning ahead, you can minimize your overall risk of investing in promissory notes and ensure the health and longevity of your self-directed IRA.
Not sure if a promissory note is the right investment for your self-directed IRA? Get started with our article, Why Promissory Notes are Becoming More Popular with Self-Directed Investors.
Risks Associated with Promissory Notes
A promissory note is a type of loan made between two individuals or a business and an individual. In this written agreement, the borrower promises to pay a specific sum to the lender by a specific date or within a specific set of circumstances. If the borrower does not pay back the promissory note according to its terms, which is known as a default, the lender can inflict the penalties listed within the note.
As a lender, there are a couple of risks specific to promissory note investments that you should be aware of as you navigate this type of investment through your self-directed IRA.
Beware of Unsecured Debt
If a promissory note is not backed or secured by any type of collateral, then you cannot take anything from the borrower in the event they cannot repay the loan. In this situation, your only means of collecting payment from the borrower would be to take legal action or to hire a collections company in an attempt to collect the debt.
Be Careful of Secured Debt
Just because a borrower puts up collateral or capital and has a good credit history doesn’t mean that some unforeseen circumstance might hinder their ability to repay the loan. Even secured promissory notes come with a risk of default.
How to Minimize the Risk of Promissory Notes
Minimizing risk in any self-directed IRA investment is about understanding what you’re getting yourself involved in and using best practices throughout the process. Because a promissory note is a legal document, it is always recommended to have legal counsel prepare and review any notes prior to execution. In our article, Use the Three Cs When Investing in Promissory Notes, we go through the most important factors you should use when determining whether or not to invest in a specific promissory note.
The three Cs are capital, capacity, and character. Together, these give a lender a bird’s eye view of a borrower and can help to determine whether a self-directed IRA should invest in a promissory note. While no investment strategy is fool-proof, using the three Cs can help you mitigate risk in the event that your promissory note goes into default, and help you recoup the sum of the loan if the worst-case scenario becomes a reality.
Action in the Event of Default
In the unlikely event a borrower defaults on a promissory note, it is the lender’s responsibility to execute the collection action necessary to claim the item(s) used as collateral.
These actions may include:
- Foreclosure (for real estate investments)
- Repossession
- Judgement
Learn More about Promissory Notes with a Self-Directed IRA
Whether you’re ready to get started now investing in promissory notes, or you still have a few questions, we can help. The team at iPlanGroup works with self-directed IRA owners to find investment solutions that fit your financial goals. Contact us today to learn more about investing in promissory notes with a self-directed IRA and about how you can mitigate your risk.
