August 29, 2023

How Investing in Promissory Notes Can Hedge Against Inflation

Written By: Daniel Gleich

Key Points 

  • One way you can offset the effects of inflation is to invest in alternative assets with a Self-Directed IRA (SDIRA).
  • Promissory notes are a popular Self-Directed IRA investment due to their potential for steady returns, tax benefits, and their tendency to be low maintenance.
  • Madison Trust streamlines the promissory note investment process so you can have a pleasant journey to a richer retirement.
Scale with a bag of money that says “loan” on one side and an image of a car and a house with a family on the other side, indicating that you can invest in a promissory note with a Self-Directed IRA.

Consumers have seen an inflation surge peaking last June, with worker wages consistently behind the cost of living. This June, the annual inflation rate in the U.S. has slowed, but is set to increase in July and August. Central bank policymakers still see core inflation running well above the 2% annual target.

To hedge against inflation, many investors turn to alternative assets, with promissory notes being a popular investment choice. The savviest investors buy promissory notes with Self-Directed IRAs due to their potential for steady returns, tax benefits, and their tendency to be low maintenance. Let’s explore more about investing in promissory notes and how adding them to your portfolio can help offset the impact of inflation.

What is a Promissory Note?

A promissory note, which is a type of private lending, is a written agreement and legal contract that accompanies a loan. It is a signed promise to pay the loan amount by a specific date and typically includes details such as interest rates, a repayment schedule, collateral, and any other relevant terms.

Outside of a bank building, to signify that when you invest in a promissory note, you essentially act as the bank and get to determine the loan terms and interest rates.

To simplify, picture yourself as a bank. You are the lender. You get to set the loan terms, interest rates, collateral, and loan amounts. You also get to decide who you are willing to lend money to and when you will receive interest and installments on the loan.

Investing in a promissory note can be rewarding. You can support a small business and see it flourish with the help of your funding. Plus, with the relative predictability of the loan’s repayment, you typically receive a steady cash flow to your Self-Directed IRA.

What Types of Promissory Notes Can I Invest In?

1. Notes Secured by Real Estate

Secured notes are promissory notes backed by the borrower’s collateral. For example, let’s say you invested in a promissory note that was secured by a vacation home owned by the borrower. In the event of default by the borrower, as the lender you are entitled to the vacation home as repayment of the note.

Two businessmen shaking hands in front of a real estate property, indicating that they have a note secured by real estate.

2. Notes Secured by Other Collateral

In some cases, the borrower may choose to pledge non-real estate items to the lender. For example, they can secure the loan with factory or farm equipment and private company stocks, among other collateral. This type of promissory note may entail more risk due to variables that can impact the collateral's value, such as equipment depreciation and the success of the private company's stock.

3. Unsecured Promissory Note

An unsecured note is a promissory note that does not hold anything as collateral to secure the debt. Unsecured promissory notes typically have higher interest rates and monthly payments to reduce the risk involved in this type of note.

Who Can I Loan Money To?

As the Self-Directed IRA account holder, you get to select who/what you want to lend money to. Like any investment, it’s important to conduct due diligence. IRS rules regarding prohibited transactions and disqualified persons are also important to understand when considering who you’d like to lend money to.

What are the Benefits of Investing in a Promissory Note?

Benefits of Investing in a Promissory Note Infographic: (1) Relatively Steady Returns – You set the loan terms, including the interest rate and repayment schedule, for relatively predictable returns. (2) Tax Advantages – When you invest through a Self-Directed IRA, the funds earned are tax-deferred (Self-Directed Traditional IRA) or tax-free (Self-Directed Roth IRA). (3) Passive Investment – Promissory notes are generally a low-maintenance investment. For example, you can indirectly invest in real estate without the added work of managing the property. (4) Portfolio Diversification – Promissory notes are not tied to the stock market’s performance, unlike standard Wall Street products. This can provide balance to your investment portfolio and a hedge against inflation. (5) Impactful Investing – Who you loan your retirement funds to is up to you. You can help a struggling business, fund a promising startup, or contribute to the redevelopment of a neighboring community.

How To Invest in a Promissory Note with a Self-Directed IRA

After you have opened and funded your Self-Directed IRA, you can invest in a promissory note by sending Madison Trust the following documents.

How To Invest in a Promissory Note with a Self-Directed IRA Infographic: Required Documents to Invest in a Promissory Note with a Self-Directed IRA. Investment Authorization Form  

Promissory Note, outlining the terms of the loan. Including: 

Amount of Loan

Date of Issuance

Interest Rate

Interest Compounding Period (annual, quarterly, monthly, daily, none)

Repayment Terms and Amortization Table if applicable 

Maturity Date

Security Document of the Loan (such as a Deed of Trust or Personal Guarantee)

If the borrower is a business entity, you also need to submit:  

Articles of Organization or Articles of Incorporation (documents certifying the formation of the entity)

Certificate of Good Standing (required if the entity has been in existence for more than 12 months)

Then, the SDIRA account holder will direct Madison Trust to send the requested loan amount to the borrower. When the borrower repays the loan, the funds will go directly into your Self-Directed IRA. For more information, please see our flowchart, How to Issue a Secured Loan from Your IRA.

How To Offset Inflation with a Promissory Note

To offset inflation, your investment must achieve a rate of return higher than the inflation rate. Promissory notes’ rate of return can range from 3-4% on the lower side to 10-15% on the higher side. In general, investors who see these rates of return can potentially meet or offset inflation.

How To Title My Private Debt Investment

When you issue a promissory note from your retirement account, it must be held in the name of your Self-Directed IRA, not your name. The lender must be listed as “Madison Trust Company, Custodian, FBO [Your Name] [Your Madison Trust Account Number].

Investors signing a promissory note and titling it in the same of their Self-Directed IRA.

Conclusion: Let's Tie It All Up

Self-Directed IRA Specialist explaining investing in alternative assets to a couple.

Investing in a promissory note can be a game-changer for your retirement strategy. It offers a diversification strategy, protection against inflation, relatively predictable returns, and tax advantages.

Do you have questions about investing in promissory notes with a Self-Directed IRA? Madison Trust Specialists are here for you!

Disclaimer: All of the information contained on our website is a general discussion for informational purposes only. Madison Trust Company does not provide legal, tax or investment advice. Nothing of the foregoing, or of any other written, electronic, or oral statement or communication by Madison Trust Company or its representatives, is intended to be, or may be relayed as, legal, tax, investment advice, statements, opinions, or predictions. Prior to making any investment decisions, please consult with the appropriate legal, tax, and investment professionals for advice.

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