For years there has been confusion about both compounding and discounting. It was actually simpler before calculators came along. Formulas are built into the calculators and choices had to be made. I’ve always wanted to talk to one of the people that developed the formulas. He’s a friend, but a little too thrilled with his own accomplishments to be questioned in this area. As the old saying goes, “he has a mind like a steel trap – rusted shut”.
I did really get a kick out of it one day when he was disagreeing about the value of some notes. I enjoyed showing him the correct numbers on the calculator and then saying something like, “I guess it’s right, you did program the formulas didn’t you?”
The confusion comes in the compounding/discounting period or periodic rate. If you want to calculate an annual yield , discount or compound a note that is a lump sum payment, you have to jump through some extra hoops to get a correct answer. Technically, the calculator is wrong. You tell it you want to discount to an 18% yield on a lump sum payment and it turns around and discounts at a periodic rate of 1.5% per month. On the surface, it sounds the same, but it isn’t. 15 years at 18% and 180 months at 1.5% are not the same. Your answer would be more correct when you are using the 15 years and one payment a year. I’ve always done it that way. I like to be precise. If it’s 18% annual yield on a balloon, then that is what I want to see. A 1.5% periodic rate is different. First let s look at compounding. You may run into this any time you pay off a loan. It can make a substantial difference financially.
If I take a $10,000 note with no payments and a balloon in 5 years at 10% interest, it would be 15,000 total if it were simple interest. I like to write notes I pay that way. The rate of 10% on a balance of $10,000 is $1,000 times 5 years. Few notes are written that way. The wording would be “bearing interest at 10% simple interest”. A normal note is compounded annually if it does not say otherwise. Annual compounding achieves $16,105.10, because each year there is interest on the previously accrued interest. Interest is compounded annually unless it states otherwise.
Title companies, mortgage companies, real estate agents and others will constantly try to charge you more because they do not understand the principle. In one of my seminars I was asked the question “John, why don’t bankers invest in notes?” A banker going through my seminar volunteered the answer. “John, if a banker has a financial calculator on his desk – it s a paper weight.” I have to straighten out their ignorance quite often. Sometimes it makes thousands of dollars of difference in the payoff of a loan. So, if you re paying on this $10,000 note and are ready to pay it off in 5 years, you owe $16,105.10. Someone may try to charge you $16,453.09 by compounding the amount monthly. That s a 10.47% interest rate – not 10%. Here s the numbers.
The same person is likely to discount in the same manner. Let s take the true balloon amount of $16,105.10 as an example. If I want an 18% yield, I would pay $7,039.69. Most people will calculate a value of $6,591.75, because they will use a periodic rate of 1.5% and 60 months instead of an annual rate of 18% and 5 years.
The true yield on the note would be 19.56% if you paid $6,591.75.
That may seem all right if someone intends to just be a bird dog and point to notes for commissions (a milk bone?) for the rest of their existence. Actually, the calculator and the time value of money have always been an entrance barrier that keeps people away from funding or investing in notes. Over the last 20 years, the sophistication and expertise of this industry has steadily declined. Fewer and fewer people have a working knowledge of the calculator. Probably 100 times as many people are in the industry with one tenth the experience. Years ago I used to work hard to teach people this. In fact, the examples in earlier books show the more precise methods. My more recent writings show the more common (but flawed) methods, because I get tired of trying to swim up stream – even if it is the right direction.
The greatest profits available in almost any form of investment are available by owning notes – not just being a broker. Brokering notes is a job. Buying notes is an investment that I know nothing that even compares to it in both safety and profitability. What it takes is creativity, the ability to fund notes and a solid knowledge of the basics. None of which can happen within the time period of a few days. The nice thing about note investment is that it can be a great job as you learn to invest. Even better is the fact that you can be paid as handsomely to invest in notes as you are paid to broker them. I always profit when I buy the note as much or more than someone who brokers it. Best of luck!