Posted by David Butler on February 17, 2001 at 16:47:02:
That is a question we encounter over and over and over… and you hear people talk in that context about discounts every day, usually in a context such as “What’s the going discount?” - especially from real estate agents!!!
Anyway… First, there is no such thing. Notes are graded individually on a number of factors, including credit rating of the Payor, down payment, value of the property, amount of seasoning, and WHAT type of collateral property is offered as security (SFR, owner-occupied or rental, commerical, land, etc). Each of these factors have a bearing on the risk rating.
Behind that will be the individual note buyer’s own risk tolerance level, which determines how much he will pay, based on dollars he is willing to expose as a function of the value of the note/security; and as a function of the yield he requires for his investment portfolio.
And ultimately, the price of the note will determine the yield the investor receives… and it is dictated by the rate and term of the note itself, rather than some preconceived discount percentage such as you are confused about.
So, let’s take the $22,000 note you describe, with:
Interest rate of 12%
Term 5 years
Yield to Buyer of 14%
What will you pay for that note?
$22,000, all due in five years plus interest at 12%, no monthly payments. Purchase price to yield 14% return to investor… $19,928****
$22,000, interest only payments at 12%, paid monthly, balance all due in five years. Purchase price to yield 14% return to investor… $20,424***
$22,000, 12% interest, fully amortized over 5 years. Purchase price to yield 14% return to investor… $21,032***
$22,000 12% interest, amortized over 10 years, balloon payment in five years. Purchase price to yield 14% return to investor… $20,640***
$22,000 12% interest, amortized over 15 years, balloon payment in five years. Purchase price to yield 14% return to investor… $20,523***
As you can see, the rate and repayment terms of the note, ultimately sets the price (all other factors mentioned above being equal, i.e. credit, property type, etc.), even though the investor’s 14% yield remains constant for all five sample scenarios.
And, as you have likely discerned, the pricing is slightly different for each repayment method - with none having any relation to a “14% discount” in this particular example, with regard to the purchase price of the note, as a percentage of the remaining balance.
Obviously there is more here than meets the eye, but I hope this helps in terms of some basic understanding.
To get a much better grasp of this concept, and how to easily perform these calculations for yourself, I highly recommend Jon Richards course, CALCULATOR POWER, which only requires a $40 investment, and is available right here on the CREO website!..
A side benefit of learning this kind of analytical capability is that the principles carryover a great deal in to other areas of your everyday personal financial decisions and strategies related to credit card restructuring, mortgage shopping, automobile financing, ad infinitum
So, happy Calculating!
David P. Butler