Interest on a Promissory Note?

Question

Hi All,

I am looking to fund some RE investments via private financing and had some general questions I was hoping the community could give me some feedback on.

Obviously, the terms around a private loan could be structured many different ways and ultimately be decided between both parties in the transaction. That being said, are there any guidelines that need to be followed? IRS reporting requirements? Minimum interest rates or maximum borrowing thresholds?

I was looking to borrow approximately $150,000. I've structured an agreement with the other party to allow me to borrow this via an unsecured promissory note. Interest would be paid monthly to the other party for 6 months until the loan would be "due" where I would then pay the original principal back in full in a lump-sum payment.

My questions are as follows:

1. Do I need to have a minimum interest % applied to the loan? I've seen some mentions about applying the "applicable federal rate" established monthly by the IRS to the loan. The other party has verbally agreed to a lessor rate but we want to make sure we are being compliant. https://www.irs.gov/applicable...

2. Is there a proper channel that the money should be "disbursed"? Could this be sent as a wire to a checking account or business account? I want to make sure this does not raise any "red flags" even though the funds are legit and sourceable.

3. Does this need to be recorded anywhere? For example, does this need to be made public and will impact by DTI as it appears to lenders or could this be strictly structured "offline" between me and the other party?

4. Any other details I should know about going with this method of financing?

Thanks in advance for the feedback!

Ned Carey · Answer

@John Morelli admitting you are a shmuck makes you not a shmuck.

Your point of many people complicating things is still valid.

John Morelli · Answer

You are absolutely right; somehow I misread or skipped the "I was looking to borrow approximately $150,000." paragraph of your post. That makes me a shmuck. My apologies.

Thomas Sulz · Answer

@Ned Carey Ahhhh, yes now we are on the same page. Got it. Appreciate the feedback that was helpful.

Ned Carey · Answer

@Thomas Sulz the rates you published see awfuly high for min rates for IRS concerns. I would use the IRS charts unless you check with a Lawyer.

As along as you have a legitimate promisory note I don't think how it is disubursed is important. No unless secured it does not need to be recorded. However it still affects you r DTI. Not disclosing debt is bank fraud. (prsuming the bank asks which is a given) The fact they may not catch it because it is not recorded doesn't make it legal to lie on a bank application.

Keep in mind if it goes bad, you may have legal trouble if you don't follow all of the rules. It maybe perceived you took advantage of the lender it you don't use a secured note or don't pay the legal min rate etc.  This is particulaly a problen in more liberal states.

One issue of  compliance is the lender needs to send you a 1099 at the end of the year to report the interest you paid.

I am not an attorney so The above is my laypersons understanding. You should contact an attorney for a transaction this big since you are not already familiar with the legalities of how to handle it. It will cost a few hundred bucks maybe. That is simply the cost of doing business.

Thomas Sulz · Answer

Hahaha, no problem!

Ned Carey · Answer

@Thomas Sulz My point about the IRS rates was, generally they are well below current rates for consumer loans. I would have expected the minimum to be lower. It is worth checking with an attorney or CPA familiar with these things to confim that this is the correct chart. It is possible that there are multiple charts with specific purposes. There may be another chart that appllies. However this is speculation on may part. Which is why to check with a legal or accounting professional.

Yes if you apply for another loan. You specifically aksed if it would affect your DTI. The only time that is an issue is if you are applying for another loan. If the bank asks on an aplication to list all your debts, you have to list them ALL, not just the ones they can find easily.

However it would not affect your credit score, because it would not be reported to credit reporting agencies. You have no obbligation to report to them.

I hope this clarifies it a bit.

Thomas Sulz · Answer

Hi @Ned Carey, the rates I provided are directly from the IRS website.Could you elaborate what you mean as to "not disclosing it" to a bank? In what scenario would I have to disclose a private loan from a private party to a bank? Do you mean if I funded a purchase/rehab in cash from the private lender and then went to go apply for a cash out refinance with another bank/lender?

Sorry just a bit confused on that part.

Thomas Sulz · Answer

Hi John, I think you've misread the post. I am not the lender in this scenario, I would be the borrower.

You also mention that I am too far in the weeds and that I should shy away from private lending becase it is "more complex than people understand". However, the entire point of my post is to get a better understanding of how the private lending process works.

Appreciate the response though!

Robin Simon · Answer

1. Do I need to have a minimum interest % applied to the loan? I've seen some mentions about applying the "applicable federal rate" established monthly by the IRS to the loan. The other party has verbally agreed to a lessor rate but we want to make sure we are being compliant. https://www.irs.gov/applicable...

You should check with an attorney, this is going to vary state-to-state

2. Is there a proper channel that the money should be "disbursed"? Could this be sent as a wire to a checking account or business account? I want to make sure this does not raise any "red flags" even though the funds are legit and sourceable.

Ideally you go through a title company but if its unsecured a bit harder.  The only issue is down the line if you are going through a bank or more traditional lender, there might be hard documentation to get proof down the line

3. Does this need to be recorded anywhere? For example, does this need to be made public and will impact by DTI as it appears to lenders or could this be strictly structured "offline" between me and the other party?

If its truly unsecured then it wouldn't need to be recorded anywhere I don't believe (not 100%, not a lawer)

4. Any other details I should know about going with this method of financing?

Your lender is the one with way way more at stake you are getting a much better deal since he really has pretty much no recourse since its unsecured

Interest on a Promissory Note?

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