Self Directed IRA Investing

So now you’ve read some of my Blog and see that I’m currently investing in Real Estate Notes in my Self Directed IRA and have cash flow coming in every month. 

Now your ready to open up your own Self Directed IRA to start your own investing program.  If you have an IRA already but it’s not Self Directed you can roll that over into a SDIRA if you like, or just open up a new one and try it out.   Just be aware of how much you contribute to make sure that your not going over the allowed limit for the year.  Also be aware of taxable events for example, if you roll over a traditional IRA into a Roth.  I would also take a little time to look at what each custodian offers to make the best choice for you.     

Until a few years ago there were just a few choices but today there are quite a few.  Here’s a list of the Self Directed IRA Custodians that I know of.   *****I’m merely listing them on my blog not advertising for anyone in particular or getting anything for it*****.

1. Equity Trust
2. Pensco Trust
3. GuidantFinancial
4. Sunwest Trust
5. Check Book IRA.com    
6. Viking Bank  a local bank for those of you in Seattle, WA.

The above list is certainly not all the SDIRA Custodians, just the ones I know about. Use Google to possibly find more.   All of their websites are quite complete with specific information about how to use their services.   Equity Trust is the only one I know of that has a blog as well.

 I hope this helps those wanting to get started but not sure where to start.

 Will

The 4 Step Grand Plan:

1. Use my Self Directed Roth IRA because of the TAX FREE benefits.  I’m also betting that all the rules pertaining to it stay the same.  I expect to be able to contribute 4,000.00 per year to it for the next 25 years.  If I stop adding additional money every year then I will end up with less but it will still be over 2 million.

2. Because of the Power of Tax Free Compounding, also known as reinvesting profits with the principal, my account will be able get to the 4 million mark in the allotted 25 years.  If I had to pay taxes on all my gains then it would be much harder and take much longer to attain this lofty goal.

3. I’m starting with $52,216.00 in my Roth IRA.  I rolled over several IRA’s and a 401k to get that much together in my Self Directed Roth IRA account.  You can see that from my last post   http://willsugg.com/irablog/2007/08/10/i-have-4-notes-in-my-self-directed-roth-ira/ what I had in cash, because of what I paid for the Notes I currently have in my portfolio.

4. If you throw out the highest Yield of 72% in my current portfolio, and average the rest.   I’m investing at 17%.  I expect to be able to continue to find good Note investments for that return or greater, as needed in the future. 

If this sounds too good to be true here’s the math broken down for every 5 years to prove it.  The chart below shows that I start with $52,216.00 add $4,000.00 every year and invest at 17%.

If I cannot contribute to my Self Directed Roth IRA account every year due to something like income limits, I can still reinvest the cash flow my investments produce.  Assuming that I keep the rest constant I will have $2,645,149  for Retirement.

I’m sure someone will also point out that in 25 years my account will be worth 2.6 to 4 million but it won’t all be in cash.  That is correct, but I will expect that the cash flow my Self Directed Roth IRA portfolio produces at that point will be quite welcome and I can start selling Notes when needed.  I also expect that I will have bought a Vacation Home using my IRA money along the way, as well as diversifying into other asset classes as well.  It’s going to be an interesting 25 years, that’s for sure.

Will

Today I’ll go over how to use a Financial Calculator for investing in Notes for your Self Directed IRA.  The one I use and like is the HP 10BII like this one.  In this post I’ll show you how to calculate a straight payment for a note and also how to figure out Yield for a Note you buy at a discount.

It’s quite easy to learn since there are really 5 keys you need to memorize.  However for this post I’ll go over the main 4 and leave the 5th for another day.  Once you have those down there is no limit to the amount of money this machine will help you make on your future transactions.  Please keep in mind all the key sequences I’ll go over work on the HP 10BII, I’m not sure about others except that the 5 basic keys will be on every financial calculator.  If you don’t have the 10BII either get one or read the manual that came with the calculator you have.

The Keys you need to learn are on the top row and labeled N, I/YR, PV, PMT, FV. 

N is the number of periods that you are going to calculate for in easy terms it’s for Months.

I/YR is interest

PV is for Present Value or the amount of the Note.

PMTis for the payment / month.  Entered in as a negative.

FV is for Future Value….I’ll cover this in another post. 

Since we now know what the keys mean all you have to really do is enter in 3 and solve for the last one.  Some examples will help explain better. 

Remember, I’m no math phd. and I hated “Story Problems” in school too, but I can do this and so can you.  I’ll bet though if the story problems in my school would have been about making money instead of how fast the car is going I would have paid more attention.   Story Problems that involve making money are very interesting to me now.

Before we begin make sure that your calculator is set up to figure out a monthly payment.  To do that turn it on and press 12 then the orange key then the PMT key.

Here’s a simple example.

1. Note:         10,000 ( Key in 10,000 then press  PV)

2. Term:        60 months (Key in 60 and then press N)

3. Interest:  12% (Key in 12 and then press I/YR )

4. Payment: ?????  ( now just press PMT)

The Result: is 222.44 per month.  Congratulations you just figured out what the monthly payment would be for a 10,000 Loan or Note for the above terms.  Notes are simply that easy.  This is one way to find Notes, is to create them.  The next time someone you know & trust needs to borrow some money you can now figure out the math to write on the a Promissory Note you either buy, or write up your self.  I would suggest that if you do, do that and create your own Note you that you secure it with some type of collateral that the borrower wants to keep and get back. 

Now that you can figure a Payment, try adjusting the Interest Rate to 20% and then Solve for Payment.

1. Key in 20 and press I/YR

2. Press PMT and you get 264.94

Go back to the original example by entering in 12 into I/YR,  and change the Months to 15 to see what happens to the payment.

1. Key in 15 and press N

2. Press PMT and your result is 721.24

Now you’ve see where once you enter in the 4 values you can change 1 and solve for another without having to enter in everything every time.  It saves you time and you can quickly see what different values can do for different scenarios.  That can be helpful when you are evaluating a Note to Buy.

For the next example I’ll get a little more complicated and show you how to figure out Yield.  Yield as I describe in another post, is your ROI or Return On Investment expressed in %.  We’ll use the same terms as above however we’re now BUYING the NOTE from someone else who needs to sell it. 

Let’s say we negotiate a good price for the Note because they have 5,000 in Credit Card debt they want to pay off, we offer 5,000 and they take it.  You already have the above example keyed in and see 222.44 for the Monthly payment.  You only have to now enter in the price you are going to PAY for the 10,000 Note into the PV and solve for I/YR. 

1. Note:         10,000 ( Key in 5,000 then press  PV)

2. Term:        60 months

3. Interest:  ??? (Now Press  I/YR, This is going to be your ROI)

4. Payment: 222.44 

 Result: you get 48.41 % that’s going to be your Yield or ROI.  It’s going to be hard to top that Yield in the stock market or any market for that matter!

If you don’t think you’ll be able to find ones like this go more conservative and enter in 8,000 in PV and you will get 22.33% for your Yield.  If you understand the Value of what the 10,000 is secured by you can then become a shrewd investor offering what you think is the best deal for the risk you understand.  These are the basics of using a Financial Calculator and in a future post I’ll write about how to Calculate Future Value or FV. 

 If you do this type of investing in your Self Directed IRA, as I do, it will no doubt grow.  With compound interest it can grow faster, and if you use a ROTH IRA your harvest will be TAX FREE!   For me that’s what it’s all about!

Will

For my first book review I decided to read Patrick Rice’s “IRA Wealth: Revolutionary IRA Strategies for Real Estate Investment”.   I had heard about the book from some friends and wanted to add it to my RE book collection. 

The begining of the book starts out with 7 Rules that are easy to follow.  Some are common sense but nevertheless it’s good to remember them.   They are:

1. Set -up Self Directed IRA
2. Transfer 401k money if possible to it.   
3. Learn the IRS rules that govern IRA’s
4. Learn all you can about RE Investments
5. Do your Homework
6. Be Prepared to Act
7. Invest new money into your IRA every year.

I followed them before I knew them all as rules and I’d argue there needs to be 1 more.  Number 8. Use a Roth IRA whenever possible for tax free distributions. 

Rice’s analogy of an investor being the Captain of your own ship really hits home with me.  I can completely identify with that by having my own “Crew” help me navigate the RE Investment waters.  He keeps this theme through out the book and to me that helps make the book easy to read and not become a tired and boring book of IRS regulations.

He describes when to use the different people in your team, which is helpful to remember that it’s easier to do this with the help of others than by yourself.  One Team member I think he may have left out is a good “Note Servicing Company”.  They help collect payments and send it directly to my IRA which makes this more of an automated process.  When a payment is late they tell me.

Rice goes in to some decent details about how you can work with family members while investing the funds of your self directed IRA.  His descriptions of what makes a true Prohibited transaction is very helpful in figuring out who in your family is eligible to invest with.  I think that part of the book is the best explanation I’ve read to date and one of the most useful parts of his book.  The chart is on page 132 fig 7.1.

Another technique that I am actively seeking to use with my next few Note purchases is T-I-C or Tenancy in Common.  On page 71 Rice describes how this could help get bigger deals done by partnering up with others.  With this the partners are in the same Position in the Note but hold a percentage of it based on how much they contributed to buy the Note.  You could then split the cash flow based on the percentage of ownership or in the case of buying a Rental Property on the sale the profit would be split in the % each T-I-C has.   

To me the single most important reason I like this book is that it opened my eyes a little wider.  I have to confess I buy Notes for my Self Directed IRA for the cash flow they provide because I’m building up reserves right now.  However Mr. Rice describes a way for someone to Buy a piece of property for retirement not just cash flow.  You buy a piece of property that you will want in your retirement years, like someplace in Sanibel Island Florida, Jackson Hole Wy, Seattle, WA with your IRA funds.  Rent it out until you retire for the cash flow and then on retirement take the property as a distribution.  Now you have your vacation home paid for and can use it as you like without any worry of prohibited transactions. 

To me understanding this and reading it is worth the price of the book and why I think everyone should get Patrick Rice’s IRA Wealth: Revolutionary IRA Strategies for Real Estate Investment.  Today!

When I am investing my Self Directed IRA money I make extra sure I know what the Face Value is of the Note I’m interested in buying.  

Face Value of a Note is a pretty simple idea.  It’s basically the value of the Note when it was originated or in very simple terms the amount printed on it.  On the Top of the Note it will say FOR VALUE RECIEVED _________.  It’s the Number printed in the line that is the Face Value. 

However if the Note has been paid for a while the Face Value and the Actual Value can be way different.   You certianly want to know the amount of money you are buying the Note for, and generally it won’t be for Face Value.  This is where you can lose serious money if your not sure of what you are buying.  Here’s an example:

I sell you a car for $10,000 at 6% interest and payments of $200.00 a month for 58 months.  I keep the Note for my Self Directed IRA.  In the very beginning (month 1) the Face Value is $10,000 because you haven’t paid 1 month yet.  

After paying for 55 months the balance or Actual Value of the Note is $531.13.  That’s how much there is  left to pay to the Note Holder but the Face Value on the Note still says $10,000.

Using your Financial Calculator  you can figure out what the difference is between the Face Value and the Actual Value of any Note you are considering buying for your Self Directed IRA.

Will

Loan to Value or LTV is very important to understand when buying Notes for or loaning money out of your Self Directed IRA.  Simply put LTV is the % debt to value for a specific property. 

The reason it’s important is you want to make sure your total cash investment is less than what the property will sell for at the Foreclosure auction.   A good figure of thumb for that is around 70% or less.  So in the case of a SFR property valued at 100,000 you want to make sure you are into it less than 70,000.   So the lower the LTV the safer your investment is.

Loan Position also needs to be taken into account as well in this equation.   In the above example if  the house was free and clear, meaning that there was no mortgages on it.  You could loan up to 70,000 and feel safe if the borrower didn’t pay, you could foreclose and get your money back at the auction.  

However if you did the same thing and there was a first mortgage already for 30,000 then your combined LTV would be at 100% in second position and you would be really risking 30,000 of your money if the borrower defaults.  Not a good investment in my mind. 

For different types of property the LTV is different. 

1. For example on Raw Land, meaning not improved, I will not go any higher than 50%. 
2. For a mobile home in a park I feel most comfortable no more than 60% LTV. 
3. For Single Family homes I’ll go as high as 70% and in the rare case depending on the borrower, location, age of home, I’ll go as high as 80%.

My best investments so far have been really low LTV, like less than 20% in first position on SFR.  I’ll buy notes like this all day and I have several in my Self Directed IRA.  I sleep just fine even though the property and borrowers are a few thousand miles away from my home, because the LTV is so low.

Lastly LTV is one of those things that will help you determine if your make a safe or risky investment.

There are a 2 basic types of IRA accounts and both are complicated enough in their restrictions and benefits. They are the Standard or Traditional and the ROTH IRA.  There are plenty of other retirement accounts like the 401K, Solo401K, Roth401k, SEP, Simple IRA, Keough, but to make this a little easier to understand and to make my point I’m just illustrating the scenario with the Traditional and ROTH IRA’s.

The Traditional IRA is nice because you can take deductions on your taxes when you contribute as long as you qualify with the rules.  You then invest the money and because of the compound interest effect you can amass great sums of money.  The problem with the Traditional IRA that hardly anyone focuses on is that on withdrawal at retirement you will PAY TAXES on any GAINS you have made!  In effect reducing the size of your golden egg significantly.  To me that is defeating the purpose.

Now don’t get me wrong I have a Self Directed Traditional IRA account.  I even invest it’s money into Notes.  The difference for me is that is not my Main Retirement account.

 My Main Self Directed Retirement account is a ROTH IRA, for 1 reason and 1 reason only and that is GAINS and WITHDRAWLS at retirement are TAX FREE.  Of course that is unless Congress decides to amend the rules someday, but if that happens there will be so many folks complaining and making a fuss so I don’t think that will happen. 

The benefit of the ROTH IRA is that you pay taxes on the money you put in first, then invest it and compounding will create that large Golden Egg for retirement.  I would rather pay taxes up front and then be able to use that money tax free for 30 years to invest at 15% interest or better than do the reverse.

I think unless you are real close to retirement right now there is only 1 account to use and that is a ROTH IRA. 

You can of course invest in Notes in a Taxabale account but that defeats the purpose for retirement funds.  What I do is keep my IRA money working first and if I still find good Note opportunities I use my cash or borrow money to invest. 

Besides your Brain, Financial knowledge, and some Common Sense, the most important tool is a Financial Calculator. 

To know how to use one, understand what it does, and how it can help you, a financial calculator will be the single most important thing you can have in your Toolbox.  My calculator has made me more money than any other thing I use to Find and Buy Notes for my self directed IRA.  A financial calculator can save you money once you have mastered it’s use.

There are many different kinds of Financial Calculators out there.  I have an HP 10bII like this one.

This calculator is very easy to learn how to use. It comes with a good manual to learn more than just the basics as well.  I recommend it to anyone who needs a financial calculator and it will pay for itself over and over again. 

I’ll write another post soon on how to use it to calculate Yield, Monthly payments, etc.

A Note is short for Promissory Note.  

A Promissory Note is nothing more than a document between parties describing a payment obligation that someone signs because they received financing for something.  Here’s and example, I go out and buy a new Gas Stove from a store and I don’t have all the money.  They offer to finance it for me and I sign a document that says I now owe the Store X amount of dollars for Y term at Z Interest rate.  It also describes what will happen if I pay early, stop paying, etc. 

Here’s another defininiton from en.wikipedia.org/wiki/Promissory_note

“A promissory note is a contract detailing the terms of a promise by one party (the maker) to pay a sum of money to the other (the payee). The obligation may arise from the repayment of a loan or from another form of debt. For example, in the sale of a business, the purchase price might be a combination of an immediate cash payment and one or more promissory notes for the balance. “

Notes are created for just about any service or thing that is sold today:

Real Estate, Mechanic Liens, Yachts, Airplanes, Motorcycles, Cars, Appliances, Businesses, Mobile Homes, Private education companies, etc. 

Will

When I look at an opportunity to invest in something the first thing I want to know is.  What is my Yield going to be?

  I want to know for X amount of dollars I put in I will get back Y amount in return.  It’s not hard to figure out but you do need a tool like the HP 10bII.  The Yield on your investment is not the same as the Interest Rate.  I normally invest in Notes for my Self Directed IRA because they return a cash flow that I can collect and then re-invest it again.    When a bank loans out money, they do this to gain an interest rate in return, or their rent on their money.  To the borrower, it’s the cost of borrowing the money from the bank.  The banks return is the Interest Rate they charge. 

Here’s an Example:

You borrow $10,000 at 10 % interest.  The payment will be $200/mo for 65 months. The Lender or bank gets $13,000.00 in total by the 65th month.  A $3,000.00 gain in profit.

Yield is different, it’s the Return on Investement or ROI. 

When I buy a Note, I buy it at a discount to the Face Interest Rate and Face Value.  The Face Interest Rate is the same thing the bank charges, but when I buy that Note for less than Face Value I’m creating a higher Yield.  The Seller of the Note will sell to me for  a discount because they need cash today instead of next year. 

 Here’s an example using the same numbers as above to help illustrate my point.

You pay $7,000  for the $10,000.00 Note with a Face interest Rate of 10 % interest.  The payment will be the same $200/mo payment for 65 months.   The Yield is 25% because you paid less than the $10,000.00.  The Lender or bank gets same $13,000.00 in total by the 65th month but now you have a $6,000.00 gain in profit because you invest only $7,000.00 not $10,000.00.

I’ll make a post soon on how to use a Financial Calculator to plug these numbers in so you can do this for yourself.

 Will