Help me understand some math from "Invest in Debt" by Jim Napier

Tax Liens, Notes, Paper, & Cash Flows Discussion 11 Replies

This is from page 98 in the book.

  • Johnny owes you $10,000 -- interest rate is 10%, payment is $132.15, number of payments is 120.
  • He's going to sell his house so he asks you for a discount if he pays it off now.
  • You agree to satisfy the debt for $8,000, because the interest at $8,000 is now apparently 15.6%.

Can someone explain this to me? Why is this transaction beneficial to you? You just lost $2000. Why is the interest higher? I must be missing something about present value, which is a concept I'm still trying to grasp.

@Jeff L.

That's a hypothetical assuming that interest rates have risen in the future. As an investor, holding a note you started 3 years ago with a 4.0 rate, if rates have risen to 7.0, you may think to yourself, "well shivver me timbers, let me dump this 4.0 paying investment vehicle, and put buy a 7.0 note. So you offer your 4.0 note to the public, but nobody will buy it from you b/c they can buy 7.0 notes elsewhere.. so you offer a discounted price for your 4.0 note in order to sell it.

Ask anything.
Jim

No company avatar mediumJim Blackburn, Guaranteed Rate Blackburn Mortgage Team | [email protected] | 7732342584 | http://www.rate.com/jimblackburn | AK Lender # AK1072866 - AK2611, AZ Lender # 0933963 - 0907078, CA Lender # CA-DBO1072866 - 413 0699, CO Lender # 100506338 - Licensed, CT Lender # LO-1072866 - 17196, FL Lender # LO30367 - MLD1102

Well, one big piece of info you left out is what did you pay for a note with a face value of $10,000? If you didn't overpay, an $8000 payoff is going to give you a profit immediately AND why would you forego the extra $2000? Velocity of money. You build wealth by taking your profits and redeploying as fast as possible. My fellow note-investors all have a standard - if a performing asset is paying them, say, a 25% ROI, they keep it. If not, they sell it. It's important to have defined goals and a system that guide your decisions.

The difference is receiving an $8,000 lump sum NOW, instead of $132.15 monthly for ten years.  

You are correct that it is a $2,000 discount.  But if you had the choice, would you want $8,000 immediately or $132.15 monthly?  Depending on your situation, choosing either is "correct".

To put it in practical terms, if you needed to pay $8,000 for a bathroom remodel today, how valuable is the $132.15 per month stretched out over ten years?

Now for the flip side:

Someone has a note paying $132.15 for ten years.  That is a total cash stream received over all ten years of $15,858.  Paying that person $8,000 now (because he has to pay for a bathroom remodel) to receive $15,858 over a ten year period calculates to an interest rate of 15.6%.  That is just a mathematical fact.

I hope this is helpful.

@Jeff L. Looks like I have a different version of the book than you (mine is copyright 1994, 2013). The scenario you described appears in a slightly different format on page 62 of my copy. It begins with this premise in mind "The true rate of interest you are paying depends on the amount of discount the person you owe would give you."

Taking the example of "Johnny" (in my book it just uses "you" and "me") owing you $10,000 at a stated interest rate of 10% with payments of $132.15 and 120 payments. Although @Gail Greenberg brings up a good point that what you originally paid for the note will make a big difference, in this case, the hypothetical example is written assuming you originated the note to Johnny and he actually owes you $10,000. The point the book makes is that if you would not give Johnny any discount if he paid you off today, then the interest rate would, indeed, be 10%. 

Then it goes on to look at the case where you tell Johnny you will give him a discount and his debt can be satisfied if he pays you $8,000, provided he pays you in three days. What is the interest rate that Johnny is actually paying if he takes you up on the $8,000 payoff? N=120, PMT=-$132.15, and now PV=$8000. If you solve for I, you get the 15.6% you mentioned in your original post. The whole point of the example was that you should never trust the numbers written on the face of the documents because as soon as you change one, the others change. The numbers are a matter of negotiation, and you should be negotiating to see if you can change them in your favor. 

As to why you might offer this type of discount, it hinges on the fact that you have placed a short time limit on your offer. You don't know if Johnny is about to sell the property, in which case you would be getting a full payoff out of the closing proceeds anyway. Napier argues that if someone asks you for a discount if they pay you in full, giving them a short timeline may end up starting a dialogue with the borrower about what is happening, and it reduces the chance they will actually pay you off short. He says most people would miss the deadline for the discount rather than raising the money.

If Johnny does end up paying you off early, then it goes back to Gail's point about velocity of money. You have $8000 NOW to re-invest in something else.

Originally posted by @Linda Hastings :

@Jeff L. Looks like I have a different version of the book than you (mine is copyright 1994, 2013). The scenario you described appears in a slightly different format on page 62 of my copy. It begins with this premise in mind "The true rate of interest you are paying depends on the amount of discount the person you owe would give you."

Taking the example of "Johnny" (in my book it just uses "you" and "me") owing you $10,000 at a stated interest rate of 10% with payments of $132.15 and 120 payments. Although @Gail Greenberg brings up a good point that what you originally paid for the note will make a big difference, in this case, the hypothetical example is written assuming you originated the note to Johnny and he actually owes you $10,000. The point the book makes is that if you would not give Johnny any discount if he paid you off today, then the interest rate would, indeed, be 10%. 

Then it goes on to look at the case where you tell Johnny you will give him a discount and his debt can be satisfied if he pays you $8,000, provided he pays you in three days. What is the interest rate that Johnny is actually paying if he takes you up on the $8,000 payoff? N=120, PMT=-$132.15, and now PV=$8000. If you solve for I, you get the 15.6% you mentioned in your original post. The whole point of the example was that you should never trust the numbers written on the face of the documents because as soon as you change one, the others change. The numbers are a matter of negotiation, and you should be negotiating to see if you can change them in your favor. 

As to why you might offer this type of discount, it hinges on the fact that you have placed a short time limit on your offer. You don't know if Johnny is about to sell the property, in which case you would be getting a full payoff out of the closing proceeds anyway. Napier argues that if someone asks you for a discount if they pay you in full, giving them a short timeline may end up starting a dialogue with the borrower about what is happening, and it reduces the chance they will actually pay you off short. He says most people would miss the deadline for the discount rather than raising the money.

If Johnny does end up paying you off early, then it goes back to Gail's point about velocity of money. You have $8000 NOW to re-invest in something else.

Thanks for walking me through this Linda. Bill too.

I understand why giving someone $8,000 instead of $10,000 for the same payments is a higher rate of interest.

I still don't understand how this is in my favor if I offer this discount. So I gave him $10,000, he immediately pays it off with $8,000...I can now reinvest $8,000 but how did I win in this situation? The whole "the interest rate is now 15.6%" seems irrelevant here?

Is it just a bad example or is there something I'm still not getting?

@Jeff L. , I don't think you should focus on what interest rate the borrower is paying as it just makes it more confusing. You don't care what THEY are paying - you care what YOU are making - cash on cash return right? You seem to be saying you're giving the borrower $10,000 and then he's only paying you $8000 as a quick payoff but that's not really what happens. Here are more typical scenarios: 

* You buy a non-performing note with a face value of $10,000 for $5000.  The borrower offers $8000 as a payoff rather than starting to make monthly payments again. You accept and now you've received a $3000 profit on your $5000 or a 60% cash-on-cash return. 

* Or, here are actual numbers from a deal I'm doing right now. I acquire a house worth $50,000 for $20,000  (I was the lender and I paid $15,000 plus costs for the land contract and forfeiture).  I re-sell the house with owner financing to a borrower for $55,000 (you can sell properties for more than market value when you offer seller finance). 

I get $3000 down and finance $52,000. If the terms are 20 years at 10%, the monthly PI payment will be $502.  I now have $17,000 invested in this deal and I'm getting $502/month or $6024/year.  $6024/$17,000 = 35.4% cash-on-cash return.

If this person wanted to pay me off at 80% of face value of the note - 80% x $52,000 = $41,600  WOULD I MIND?  No, I would not.  

@Jeff L.

They explained it well...just wanted to say investing in debt either through buying notes or originating notes can be a great niche. If you don't want to get that involved, invest in a HML fund. Some pay 12% or thereabouts which is a decent return.

No company avatar mediumJohn Thedford, John Thedford | 239‑200‑5600 | http://www.capehomebuyers.com | FL Agent # SL3098153

@Jeff L. , I understand the logic of your question. I'm hoping that "the book" distinguishes between "Johnny owes you $10k" and "You GAVE Johnny $10k as a loan" - because I see those as two very different points. Subsequent responses do seem to hone in on determining what your ACTUAL cost of the "$10k" would have been, and I would have hoped that "the book" would have made the same distinction - but, didn't? Cheers...

To @Brent Coombs ' point, I looked back at the wording of the book. The scenario is "Johnny owes you $10k." It actually doesn't say anything about how much the loan originally cost you or who originated it. So, my previous remark about the example assuming you originated the note for $10k isn't necessarily correct. 

I think we would all agree that making a $10k loan to someone and then immediately turning around and accepting an $8k payoff wouldn't be a wise use of your $10k. I don't think this was the intent of the example in the book either. I think it was just illustrating the point that the numbers in the docs aren't set in stone and you should negotiate things in your favor (whatever you decide "in your favor" means for you). The example could have been written better though.

@Jeff L.

I see the problem now.

You don't have enough players in the picture.  

Person L (lender) loans Johnny $10,000 at 10% for ten years.

IMMEDIATELY after signing the docs to lend Johnny the money, person L's wife finds out and nearly goes postal on person L for lending that money because she wanted to remodel the master bathroom.

Person L learned shortly after saying "I do" that age old axiom "Happy Wife, Happy Life".  Therefore that ten year stream of income that would yield a total of $15,000 plus doesn't look like such a good idea anymore.

Enter YOU!!

You evaluate Johnny as a borrower and do ALL your other due diligence on the note and the borrower and feel it is a good risk and worthy investment.....IF Person L will sell you the note for $8,000 so that you realize your target interest rate.

Now.....this was not a politically correct post.  It was meant to merely bring a smile, not to offend.  If anyone is offended, I hope that  you will substitute "husband" for "wife" and "fishing boat" for "master bath"......hopefully everyone will see that there was no intent to harm or demean.

I just re-read the original question:

I'm not at home to review my worn and dog eared copy of the book, but I believe that if you review the scenario, you'll find that the individual offering to accept a payoff of $8,000 is NOT the original lender.  Offering to accept an early payoff is a tactic Jimmy Napier uses to accelerate his velocity of money.

I think you'll find that the offer to accept $8,000 was made by someone who purchased the note at a price that was LESS than $8,000.

I hope this helps.