Large companies like fortune 500 companies have long invested their 401ks and pensions in notes/deeds to receive high returns. You can do the same with your self-directed Solo 401k. This type of investment is straight-forward and can be very profitable. Further, you, as trustee of the Solo 401k have control to set the terms of the note from the rate of interest to the maturity date of the loan.
What is a promissory note?
A promissory note a promise to pay, and is a legal document that obligates the borrower to repay the loan at a determined interest rate during a specified period of time. When a Solo 401k participates in a note, if the borrower fails to meet his or her promise, your Solo 401k will have the right to foreclose on the property securing the note, and, ultimately, take possession of the property if the borrower does not pay.
The Promissory Note Terms
The note terms typically include the sum of money to be repaid to the Solo 401k, the interest rate to be paid on the loaned amount, and the length of the note (i.e., when the note requires full payment). Therefore, each of these variables affects the value of the note. The value of the note is also dependent on the borrower (i.e., the likelihood that the borrower will not default on the loan).
Promissory Note Payment Amount
Before investing Solo 401k funds in a promissory note, you should determine the value of the property securing the note. For instance, if the note is secured by real estate, the loan-to-value ratio, or LTV should be determined. A note with a lower loan-to-value ratio–in other words, a note in which the amount of money borrowed is smaller in relation to the property’s value – is a better deal than a loan with a higher ratio. An example would be property with a value of $100,000 and a loan of either $30,000 (30-percent LTV) or $70,000 (70-percent LTV). The 30-percent LTV is a much more secure investment. Since the borrower has greater equity in this case, the borrower has more to lose and, therefore, more incentive to pay. Further, should you have to foreclose, your Solo 401k will gain an additional $70,000 in equity, instead of the $30,000 your Solo 401k would receive with the $70,000 loan.
Interest on Promissory Note
When investing your Solo 401k in notes, you will need to decide on interest to charge. There are two types of interest: simple and compound. Simple interest is interest that is paid on the principal, or the loan amount. For example, if your Solo 401k loaned $400 to your brother for a year and charged him 1 percent interest, at the end of the year, he would pay you $4 in interest plus the principal of $400, for a total of $404.
Compound interest is interest paid on both the principal and the accumulated interest of prior periods. If you loaned your brother $400 for one year but charged him 1 percent interest each day – put differently, if the interest were compounded daily–he would owe you $404 at the end of the first day, $408.04 at the end of the second day, and so on.
Types of Promissory Notes
Secured–generally considered safest of the loan types because it’s backed by collateral such as real estate or equipment. If the borrower stops making note payments and therefore defaults, the lender (Solo 401k) will take over the asset securing the loan; in this case real estate or equipment instead of receiving payments.
Unsecured–because the loan is not secured by collateral (e.g., real estate or equipment), and if the borrower stops making payments, your Solo 401k’s only option in trying to enforce payments is to take legal action against the borrower.
Processing the Promissory Note/Trust Deed Investment with Solo 401k
- After you have drawn up the note or if the borrower has composed it, review the note to make sure it conforms to your Solo 401k requirements and is in compliance with the regulations.
- Confirm that the lender is your Solo 401k (it should read as follows, for example: Jane Do Solo 401k Trust)
- Sign all documents as trustee of your Solo 401k
- Make investment using funds from your Solo 401k checking account
- When note payments commence, deposit all payments to your Solo 401k checking account (therefore, all payments need to be made payable to your Solo 401k)