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The Difference Between Secured and Unsecured Private Lending

Estimated reading time: 3 minutes, 32 seconds

Private lending is truly a historical investment method, perhaps dating back to the first millennium AD. But today’s investing world considers it an alternative investment method.

Many investors, however, consider private loans to be a great way to diversify beyond the traditional stock and bond markets. Plus, lending investments can result in regular cash flow due to their predetermined payment amount and interest rate.

Private notes establish the rights and duties of the lender (the account) and borrower (a private individual or entity) in a lending transaction. This is a legally binding contract. The borrower agrees to pay a certain amount of money (which may include interest on principle), in installments, on demand, or in full at a specified time. Repayment options might be fixed principal and interest amortized over a set term, a balloon payment of interest and principal, or interest-only payments with one balloon principal payment at the end.

The borrower must be a non-disqualified person or entity. And if the borrower fails to make payments on the loan, the loan will default.

Today’s blog post details the two types of private lending investments: those secured by property and those unsecured.

A secured note is any lending investment collateralized with real property like a first deed of trust, mortgage, company stock, and more. So, if the borrower defaults, the lender—perhaps a Self-Directed IRA—is then entitled to the underlying collateral (such as the trust deed).

To illustrate, let’s say you have a coworker needing $5,000 to make emergency repairs to his home. You don’t know a ton about his financial situation (though he has mentioned a mortgage and student loans). Because of outstanding debts you know of, as well as those you may not, you won’t commit to a loan without it being backed by real property. You’re afraid that without some collateral, you run the risk of a loss on the investment if he defaults. Therefore, you offer to loan the money from your Self-Directed IRA via a secured promissory note, with his car serving as collateral.

You can also loan money to a company via a promissory note, with collateral being corporate stock. A secured note, in this example, has a different level of risk since the success of the issuing company can directly impact the value of the collateral.

Conversely, an unsecured note is any lending investment not secured by collateral (or uncollateralized). The loan is therefore made on the borrower’s ability to repay it.

For another example perhaps you have another acquaintance needing a similar emergency loan. This close friend is debt-free, both personally and in her small business. In fact, her business is very well-respected in the community.

She would simply like a longer payment schedule than what’s offered at the local bank. She’s willing to pay a higher interest amount to get it, and you trust she will pay back the loan. You fully expect to see your return of principal plus interest, so you agree to an unsecured promissory note.

For an entity example of unsecured private lending, maybe you provide a bridge loan to a startup seeking debt financing. Again, since this is an unsecured note, you are trusting the company will grow and pay back the note. Note how this is unlike a private equity investment where the loaned amount includes the purchase of securities. No company securities are purchased in this case.

Regardless of the borrower type or whether the loan is secured or unsecured, you must perform the proper due diligence on the investment.

The borrower must be vetted (do you foresee any issues months or years down the road?). The payment timeline must be understood (does it fit with your larger investing goals?). Is it a risk you’re worth taking? Is the collateral, where applicable, adequate for the default risk?

Are you ready to consider a private lending investment? Consider adding Kingdom Trust to your team of professionals as your independent, qualified custodian. Not only can we custody promissory notes and other private lending investments, but you can also combine loans with crypto assets, real estate, private equity, precious metals, even stocks and bonds—all in the same account!

Different paperwork is required depending on the exact nature of your private lending investment. So, chat with us today right from this page or call 888.753.6972 for ways to get started!

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