Are Unsecured Notes Worth the Risk?
Investors with self-directed IRA and Solo 401(k) plans are always looking for ways to put their tax-sheltered savings to work that can produce better than average returns.
Investing in notes is a popular choice. When done well, note investing can be a great way to diversify a portfolio, generate solid returns, minimize volatility, and have more control over the investment lifecycle.
When a note is backed by a secure asset such as real estate, there is also a certain amount of protection that comes with the investment. In the event of a default by the borrower, the lender can foreclose and take possession of the property.
Some notes are not directly secured by an asset, however. These are referred to as unsecured notes. While the promised return on investment can often be quite appealing, there are some significant risks to be considered when investing in unsecured notes.
What are Unsecured Notes?
An unsecured note is simply an agreement between a lender and a borrower where money is lent for an agreed upon purpose. The borrower promises to repay the loan, but does not offer any specific tangible asset as collateral for the loan.
A lender can agree to make the loan, but they are solely reliant on the willingness and ability of the borrower to repay the loan. If the borrower defaults, there is no asset that can be claimed by the lender in lieu of payment.
Because there is more risk in an unsecured note, the interest rates are typically higher, which is why some investors are drawn to such opportunities.
What are Some Common Types of Unsecured Notes
A loan for most any type of transaction can be offered on a secured or unsecured basis. The only difference is whether the loan is securitized by collateral of real value.
Unsecured notes are common in certain type of real estate transactions, especially where there is a shorter timeframe involved.
Flip transactions are one of the more common areas where a real estate investor may seek an unsecured loan.
While they could have a note secured by the property being flipped, there is a cost in terms of time, paperwork, and recording. If the investor can get a lender to trust that they will perform and repay the note when the flip is completed, they can move more quickly and spend more time doing deals and overseeing rehabs than sitting in title offices signing documents with an unsecured note.
Some real estate investors seek unsecured notes to their flipping business such as a LLC. The argument here is that they turn properties over quickly, and will be able to keep a lender’s money more actively deployed if they do not have to open and close an individual secured note for each property.
Unsecured notes are also common in mezzanine financing and transactional lending situations.
What are Some Advantages of Unsecured Notes?
Borrowers benefit from unsecured notes in several ways.
Unsecured notes are typically simpler to issue and manage than secured notes, as they do not require the creation and management of a security or collateral.
Issuing unsecured notes may be less expensive than issuing secured notes, as there are fewer costs associated with the creation and management of a security or collateral.
Unsecured notes can provide greater flexibility for borrowers, as they are not tied to specific assets or collateral. This can make it easier for borrowers to obtain financing for a wide range of real estate projects.
The main advantage for lenders is the potential for higher returns. Unsecured notes can offer higher returns compared to traditional investments, such as savings accounts or bonds, due to the higher interest rates they can command.
What are the Key Risk Factors?
The main concern with unsecured notes is the risk of default. If a borrower cannot pay, the lender does not have collateral they can foreclose upon.
There are other risks as well, including lack of liquidity. With a secured note, it is often possible to resell the note to another investor if you find you need to apply your capital to a different purpose. Not many investors will buy an unsecured note at resale for anything close to its original value.
But the main risk in our opinion is fraud.
What is the Fraud Risk?
Unsecured notes, like any other financial instrument, can be subject to fraud. While there are certainly many legitimate unsecured note transactions out there, they do provide greater opportunities for unscrupulous parties to defraud investors.
When you invest in a secure note, you can request a copy of a recorded deed and see the actual asset that is pledged as collateral.
With an unsecured note, you really only have a promise on the part of the borrower to pay.
Well, what if the borrower says they are going to flip a house and pay your IRA 18% interest, but they then take the money and spend it on a trip to the casinos or that new Lamborghini they have been hankering for? Sure, you can call the state attorney general, and that person may end up in an orange jumpsuit, but your IRA will probably not see the invested money again.
How to Mitigate Risk?
It is important to be aware of red flags or warning signs that may indicate a potential fraud, such as guaranteed high returns with no risk, pressure to invest quickly, or a borrower asking for a higher dollar amount than you may be comfortable with.
Requests for personal or financial information can also indicate predatory practices.
The best thing to do in these situations is slow down and ask someone you trust, preferably someone who has investing experience, if the deal sounds right.
To reduce the risk of fraud, it is crucial to thoroughly research the borrower, including their background, experience, and track record. It is also wise to work with a trusted financial advisor or investment professional.
In conclusion, while unsecured notes may offer higher returns compared to traditional investments, they come with significant risks. It is essential to weigh the potential benefits against the risks, and to conduct due diligence before investing in unsecured notes. Investors should consider working with a trusted professional to minimize the risks associated with unsecured notes and to ensure that their investments are in line with their financial goals and risk tolerance.
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