Promissory notes can be a profitable way to make investments with the Solo 401k account. The investment is simple, and easy to execute with your retirement plan. As with any self-directed Solo 401k investment, you are the trustee of your 401k plan and thus have the control to establish the note terms, including the interest rate and repayment date of the loan.
For some investors who want to dabble in real estate, but might not be ready to purchase a property outright – the promissory note can be an excellent way to get started.
In fact, many larger corporations have long invested their pension funds into promissory notes, as a way to maintain some liquidity while garnering handsome returns.
What is a promissory note?
A promissory note is a signed document between two parties that contains a written promise to pay an agreed-upon sum, at a specified date. In simpler terms, a promissory note is a promise to pay or an IOU.
What are the different kinds of promissory notes?
A promissory note can be a promise to pay for any number of things, including a personal note (where an individual promises to repay a loan on set terms. Often, a promissory note will refer to a promise to pay on a piece of property. This might also be called a mortgage note. There are a number of different types of promissory notes your Solo 401k might lend on, including:
Secured notes: often considered the lowest-risk of promissory notes. Secured notes are “secured” by real assets, such as property, equipment, etc. If the borrower stops paying on the loan, the lender (in this case, the Solo 401k trust) can claim the asset as part of the repayment terms. In the case of a promissory note such as mortgage note, if the repayments are not made on time, or stop completely, the Solo 401k trust can foreclose on the property involved in the note.
Unsecured notes: these loans can be a bit more of a risk to the lender. Unsecured notes are not secured by any physical property. Only the word (promise) of the borrower is in the note terms. If the borrower stops paying, the recourse is to take legal action against the borrower in an attempt to make him pay. As these notes are often higher-risk, many lenders will have higher interest rates, or stricter terms reflecting this increased risk.
Mortgage notes: this type of promissory note might also be called a real estate lien note. This is a type of secured promissory note where the specified mortgage loan is what is securing the note.
Private notes: private promissory notes are between two parties, often the Solo 401k trust (as the lender) and the borrower, who can be an individual or corporation. These notes can be secured (perhaps by personal or company property) or unsecured.
Before the Solo 401k considers lending on a promissory note, take into consideration the value you’d place on the loan. Is this a piece of property, or an unsecured note to a private party?
If the note is secured by real estate, you may consider the loan to value (LTV) ration on the mortgage of the property. If you have access to multiple borrowers, or investors who want the Solo 401k to write notes, it’s worth considering the best “deal” for your Solo 401k.
Generally, a note with a lower LTV can be a safer deal. This is not only because less money is owed on the property, but also because the property investor owns more equity of the property. Therefore, if there was a default, and the Solo 401k foreclosed on the property, your Solo 401k would owe less on the remaining mortgage. Additionally, as the borrower has more invested into the property (more equity), they will be more willing to keep to their payment schedule on time as to not lose the investment.
However, a higher LTV note could garner more interest or more favorable terms for the Solo 401k as the lender because the risk is higher. That risk of greater default (because higher LTV means less equity in the property), must be weighed against the potential higher returns of greater interest. As with all investing, the name of the game is strategy!
Who is the lender on the note?
Your Solo 401k trust is the lender. Use the Solo 401k trust tax ID number associated with your plan wherever an employer identification number (EIN) or tax ID number is requested.
Who decides the note terms?
The note terms are often determined by both parties involved in the note. However, this again can vary from deal to deal. If the borrower wants the funds badly enough, they may allow the lender (Solo 401k trust) to dictate the entire loan terms. Conversely, if the borrower is attractive enough for safe and secured investments, the lender may be more open to negotiating terms with respect to interest and repayment timeline.
Who determines the interest rate?
As noted above, who determines the interest can vary from deal to deal. If the lender (Solo 401k trust) is determining the interest, there are a few items to decide:
- What will be the interest rate on the loan?
- Will the loan have simple or compound interest?
Simple interest is interest paid on the principal (the loan amount).
Let’s take a look at an example: Imagine your Solo 401k lent $100,000 to a private investor as a secured mortgage note with a 3-year term (this means the loan will be paid back within three years). You’ve determined the interest to be 6% annually. The interest payment would be $6,000 per year, or $18,000 at the end of three years (on top of the $100,000 principal you’d get paid back). Most car loans will use simple interest calculations.
Compound interest is calculated not only on the principal loan amount, but also charges interest on the interest over time. In other words, the unpaid interest at the end of the first period (typically a year but this also is up to definition in the promissory note terms) is added to the principal for the second period, which allows the interest to compound.
Let’s look at our example from above, but this time using compound interest on the note terms: Imagine your Solo 401k lent $100,000 to that same private investor with a 3-year loan repayment. You’ve set the terms so the compound interest is at 6% annual interest rate. That means you’d get the interest for the first year is $6,000, the second year $6,360, the third year $6,741.60. Instead of $18,000 total interest earned on the life of the note, you would receive $19,101.60. That’s $1,101.60 more than the total interest paid on a comparable simple interest loan.
What should be listed on the note agreement?
The promissory note will generally list the parties included (lender and borrower), the principal loan amount, the total to be repaid, interest rate (simple or compound), and the loan term (in what time the loan must be repaid). Each item above can affect the value of the note. You’ll also want to take into consideration the probability of the borrower’s ability to repay the loan (both on time and in full).
If you are lending funds from the Solo 401k for the promissory note, the Solo 401k trust is the lender.
It’s a good idea to have your legal counsel or loan servicing agent draft the promissory note, amortization schedule, and repayment schedule to ensure it’s drawn correctly. The Solo 401k trust should be listed as the lender and the borrower’s information should be listed as well. It is possible for you to draft your own note paperwork since you are the plan trustee, but unless you have experience in both drafting promissory notes and titling assets in the name of your Solo 401k trust, we recommend you engage a professional to assist.
How do I keep track of payments?
You can keep track of loan repayments via your favorite accounting software, or even an excel spreadsheet. It’s a good idea to compare bank statements with your own records, to ensure the loan repayments and interest are happening on schedule and in the correct amount. Having your CPA and/or bookkeeper reconcile the payments at the end of each year is also advised.
If the note is secured, (where assets are securing the loan) the responsibility of accurately recording the asset which is securing the loan is your responsibility because you are the trustee of your Solo 401k plan. Alternatively, if you are using a loan servicing agent, they can take the responsibility of properly recording the secured asset. This way, if the loan is not repaid, your Solo 401k trust will have documentation that it has rights to claim the asset as part of securing the note.
What paperwork should I look for from the borrower?
The Solo 401k as the lender will lend money either to an individual or an entity (such as an LLC, S-Corp, etc).
If the Solo 401k is lending to an individual, there may be a number of items you ask for, including a copy of their photo ID and proof the borrower says they are who they claim to be (this is especially important if you’ve never done any lending to this particular party). You may ask for documentation to prove they are able to repay the note. If the Solo 401k is lending to an individual on a secured noted, you may ask for a copy of the mortgage deed with the Solo 401k trust listed as the beneficiary (in the case of the note default).
If the Solo 401k is lending to an entity, it’s wise to ensure the entity is legitimate and in good standing. You or the borrower can procure a certificate of good standing from the Secretary of State website who formed the entity. Additionally, you might ask for a copy of the Operating Agreement (for an LLC) a partnership agreement (for an LP), or a list of shareholders (for an S-corp or C-corp).
What are the steps to make a promissory investment with the Solo 401k by Nabers Group?
- Establish your Solo 401k with the experts at Nabers Group
- Fund your Solo 401k from rollovers and/or contributions
- Connect with your borrower
- Draw up the promissory note (you or the borrower can draft the note. Alternatively, you can have your legal counsel or a loan servicing agent draft the note, repayment schedule, amortization schedule, etc).
- Review the note to confirm your Solo 401k Trust is listed as the lender. Make sure the note is in compliance with IRS regulations.
- Sign the note documents as trustee of the Solo 401k trust
- Complete the investment using funds from your Solo 401k trust bank account
- Note repayments should go right back into your Solo 401k trust bank account (no deposits to your personal or business bank accounts allowed)
Promissory Note Frequently Asked Questions
- Are a promissory note and a mortgage note the same thing?
A mortgage note is a type of promissory note, but a promissory note is not necessarily a mortgage note. You can write a promissory note as a personal loan to an individual, or even a loan to purchase equipment. However, promissory notes as mortgage notes are very popular among self-directed investors.
- Can I write the promissory note lending money to my business?
No, the promissory note is just like any other investment completed by the Solo 401k. Your Solo 401k cannot lend money to any disqualified persons, including yourself and any businesses you own. The Solo 401k writing a promissory note and lending to your business would constitute a prohibited transaction.
- Who is responsible for creating the promissory note paperwork?
You or the borrower can write the promissory note, loan repayment schedule, and amortization schedule. Alternatively, you can have your legal counsel or a loan servicing agent draft the note, repayment schedule, amortization schedule, etc). Whoever writes the paperwork, ensure the Solo 401k trust is listed as the lender.
- Who keeps track of note repayments?
As the trustee of your Solo 401k, it is your responsibility to keep track of loan repayments. As with any investment, you want a finger on the pulse of how your investments are doing. If your Solo 401k owned rental property, you would take notice of 3 months of vacancies as there would be no money. Similarly, keep track of your loan repayments to ensure they happen in a timely fashion.