A Crash Course on Discounted Paper (Part 1)

by J.P. Vaughan   

My earlier article, How To Create Your Own Mortgage generated a lot of interest and enthusiasm among our web site visitors, as well as tons of questions. I hope this two-part article removes some of the mystery surrounding discounted paper and clarifies the topic for you.

Before you can create and sell a private mortgage to fund a real estate purchase, you must become familiar with some basic principles. If you are an investor who would like to create your own mortgage to finance a real estate purchase, understanding these concepts will help you structure your mortgage, so you can make it attractive to investors and sell it quickly.

If you are an investor who is interested in investing in discounted paper, understanding these principles will help you to develop sound investment criteria.

The time value of money

Money loses buying power over time. One dollar bought much more 100 years ago that it buys today. Likewise, because of inflation, we assume one dollar will buy much less a hundred years in the future than it does today. Therefore, money was worth more in the past because it had more buying power. Money will be worth less in the future because we'll need more of it to equal the buying power we have today.

Modern financial calculators and computer software use a built-in mathematical formula to discount today's dollars to make them equivalent to future dollars. This time-value-of-money calculation compensates for the loss of future buying power.

Interest rates play a role

Lenders compensate for the loss of buying power over time by adding a charge for the use of their money. That charge is called interest. Interest is calculated as a percentage (such as 10%) of the loan balance. In return for borrowing money today, the borrower agrees to pay back the original loan amount, called the principal, plus interest.

Interest rates vary from time to time, depending upon the state of the economy and Federal Reserve Board policy. Risk is another element that influences interest rates. Lenders look at two main factors to determine the amount of risk involved in making the loan: (1) The people who are borrowing the money; and (2) the collateral (or property) securing the loan.

In theory, loaning money to someone who has perfect credit is less risky than loaning money to someone with bad credit. Therefore, the person with perfect credit can obtain a loan at a much lower interest rate.

Someone with perfect credit should obtain a mortgage from a bank because it is much less costly than private money. Someone with bad credit cannot get a bank loan at any interest rate. But private investors will still make the loan under the right circumstances.

When the borrower cannot show a good credit rating, the investor will charge more in interest and require that the value of the property securing the loan is worth a great deal more than the loan amount.

If the property is worth $100,000 and the loan is for $60,000, the investor has a $40,000 cushion if the borrower defaults on the loan. If the investor must foreclose, that $40,000 cushion becomes the investor's profit when the property is resold.

Loan-to-value is the "cushion"

Loan-to-value (LTV), is the loan amount divided by the market value of the property. It is the "safety margin" or "cushion" investors and bankers require when they make a real estate loan or purchase an existing mortgage.

If a house is worth $100,000 and the loan amount is $70,000, the LTV is 70% ($70,000 / $100,000 = .70). The other 30% of value not included in the loan amount is called equity.

The equity is the investor's cushion. If the loan goes into default and the investor must foreclose, the $30,000 of value over the loan amount (the equity) becomes the investor's profit when the house is resold.

When you structure a mortgage to sell to the private investor market, or when you purchase a mortgage for your own investment portfolio, the LTV must provide a good cushion. The LTV must be low enough for the investor to feel comfortable buying the mortgage.

Remember, if you are not using your credit to finance the property and cannot demonstrate a "good track record" to the investor, the investor must look only to the property for security.

That security needs to be substantial. How much security do you need to entice a private investor? The answer depends upon your local investment community, the particular investor's needs, and the amount of yield you are offering on the mortgage.

In general, the higher the yield, the less security you need. That means, for example, that if you are offering a 22% yield, the investor may settle for a 70% LTV. If you are offering an 18% yield, the investor may require an LTV of 65% or even 60%. The investor balances the risk versus the reward. In other words, a higher reward may justify a higher risk.

You will have to test your local investment community by talking with investors to determine what percentage LTV is acceptable in your area. Normally, a 70% LTV is the maximum level of acceptable risk for this kind of private mortgage, regardless of the yield offered.

A complete understanding of discounted paper is the key to many successful real estate transactions. In A Crash Course on Discounted Paper (Part 2) I'll explain the difference between Interest and Yield and how the Term of the mortgage effects the Discount and Yield.

About the author...

j.p. vaughanJ. P. Vaughan was the co-founder and Publisher of Creative Real Estate Online. She wrote the book How to Buy Your Dream House for 1/2 Price (Quantum Publications 1994, out of print). J.P. was also an attorney who practiced law in Michigan until she started investing in real estate full time in 1988.

J.P. passed away in October 2015 after a long battle with ovarian cancer.

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