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When you sold your home, you were happy to help the buyer out by taking back a second mortgage for the last bit of purchase price: $10,000 at eight percent, which was more than the going mortgage rate last winter. Everyone was happy. Monthly payments of around $84 were set to amortize the loan in 20 years. And the buyer has been making the payment faithfully.
So now you’ve decided that you’d rather have the money, and you’re ready to sell that mortgage. But no one seems willing to give you $10,000 for that nice investment.
A Note About Notes
For starters, it’s important to understand the time value of money, which is neatly summed up in the question:
Would you rather have $1 today, or $1 a year from now?
That one’s easy.
Even if you keep your money in a stodgy bank account, you can probably expect to earn at least 5 percent with it. So if you got the money today, you could turn it into $1.05 by a year from now. That means next year’s dollar is worth only 95 cents today–actually a bit less, because 95 cents wouldn’t earn quite that full 5 cents in interest.
That explains the first reason why no one will give you $10,000 today, for the right to collect that debt when the last bit of repayment is scheduled for 20 years from now. The calculations are a bit complex, but there’s a formula for figuring the present value of a stream of income over that period of time – depending, of course, on what rate of interest is involved.
Investor Expectations
Which brings us to the second reason for your discount. It lies in the expectations of the investor who offers to buy your loan. Your motivation for lending the money was probably to get the house sold, and 8 percent interest sounded better than you could get in a savings account.
But the investor who lays out cash today expects a higher return than that, to compensate for the risks involved and the inevitable losses when some mortgages turn sour.
Sizing up the Competition
Your mortgage note is in competition with other possible investments. To take only the most extreme – and safest – example, even Treasury notes these days yield more than six percent, free from state income taxes, at absolutely no risk. And of course with increased risk all sorts of other investments beckon – with higher returns.
Why then would anyone buy your note, laying out cash today and taking on the risk of default in the future, for the full face value?
No one will.
The amount you will be offered depends on the investor’s own guidelines for anticipated return.
If an investor requires at least, say, 15 percent before he or she will be motivated to buy your note, then calculators, computer programs, or algebraic formulas will be used to determine the price you’re offered.
What’s your discount?
But one simple way for a rough estimate is to consider the question: how much of a loan would $84 a month repay, amortized on a 20-year term, at 15 percent interest?
The answer is somewhere around $7,000.
And there’s your discount.
Source: NoteWorld.com

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