I was having dinner with seven other real estate investors, and the topic of private lending came up. We were sharing various horror stories and boo-boos we had made. Some of the mistakes I made when I was first learning to self-direct my retirement account are rather embarrassing.
There is one mistake, however, that multiple people have made and shared with me, and that is allowing either the borrower or borrower’s counsel to draft the Promissory Note, Mortgage or Deed of Trust. Let me be very clear – I highly discourage doing this! A knowledgeable investor who is lending from a retirement account or other non-tax-qualified fund should be able to draft their own lending documents and have them reviewed by a lawyer of their choice. If you are not yet knowledgeable in preparing the necessary documents, you need to retain an attorney who is.
One of the documents you need to be able to draft is the Promissory Note, which should be framed as a “Commercial Promissory Note,” as I believe you should avoid lending to consumers. There should also be a Personal Guaranty signed by the principals behind any borrowing entity. Since the actual borrower is often an LLC or trust, and the manager of the LLC or trustee of the trust is signing the Promissory Note, I want the members (owners) of the LLC or the beneficial owners of the trust to be signing the Personal Guaranty.
Other documents needed include a Mortgage or Deed of Trust securing that loan to collateral that is worth more than the amount of money being lent, and possibly a Construction Draw or Escrow Agreement. All these documents need to fit together in a seamless package.
One of the most overlooked documents in private lending arrangements is the Closing Instructions Letter, which gives written instructions to the title company or closing attorney who is handling the transaction. (Side note: If you are thinking of lending directly to the borrower and then later securing that Note with a Mortgage on property they subsequently bought with that money, you are setting yourself up for disaster.) The closing instructions should lay out the sequence of how the closing should go from the borrower’s perspective and all the criteria that must be fulfilled before the funds that are on deposit in the escrow account of the title company or closing attorney can be released to fund the deal.
If you are a beginning investor, one of the things you may want to do is look up the definitions of the various terms I have mentioned in this email so you can become familiar with the various documents and what they do as part of a private lending arrangement.
In my next few posts, I will share more about some of the documents you need to understand and use.