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Note or Not

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THE SCENARIO My friend John recently contacted me about a note he was considering purchasing. He's a smart guy, but is new to notes, and wanted a second pair of eyes on the analysis. Fair warning: this has multiple parts, but none of them are overly complicated. The note has a 30-year term, fixed interest at 9.5%, and $76,000 originally owed (the 'face amount' or 'face value'). Some quick calculator work revealed that the monthly payment is $639.05. John knows that it's good to get a discount when you buy notes, and wanted to make sure he got at least a 45% discount. The seller was offering the note for $76,000 x (100% - 45%) = $41,800. So far so good. The problem arose when more details about the note emerged. Namely, 25 of the 30 years have already elapsed, and John would be purchasing only the last 5 years (60 payments) of the note. The Questions:
  1. If John bought the note as currently offered, what would his ROI be?
  2. How much is currently owed on the note?
  3. If John bought the note at 45% of the currently-owed amount, what would his ROI be?

THE SOLUTION First things first, make sure the calculator is using 12 Payments per Year, which we'll use for all of the calculator problems we have to do. Part 1 First, we need to figure out what John's ROI would be if he bought the note as offered. N: 60 (The note only has 60 payments remaining) I/YR: (This is what I'm trying to find) PV: -41,800 (John would purchase the note for $41,800) PMT: 639.05 (The note payments are $639.05 per month) FV: 0 (The note is fully paid at the end)

If John bought the note as offered, he would make -3.35% on his investment. Something's not quite right here...

Part 2 Second, we need to find out how much the borrower owes today (they've been paying the note for 25 years, which is 300 months). N: 300 (They've been paying for 25 years) I/YR: 9.5 (The interest rate on the note is 9.5%) PV: 76,000 (The borrower originally owed $76,000) PMT: -639.05 (The borrower pays $639.05 per month on the note) FV: (This is what I'm trying to find)

The borrower currently owes $30,428.22 on the note. Clearly, if John pays $41,800 for this note, he's overpaying.

Part 3 Third, we need to find out what John's ROI would be if he bought the note at a discount from its currently-owed balance. If John gets a 45% discount on the currently-owed balance of the note, he'd pay $30,428.22 x (100% - 45%) = $16,735.52. N: 60 (There are 60 payments left on the note) I/YR: (This is what I'm trying to find) PV: -16,735.52 (With his desired discount, John would pay $16,735.52 for the note) PMT: 639.05 (The note payments are still $639.05 per month) FV: 0 (The note is still fully paid at the end)

If John were to purchase the note at the discounted price, he'd make 39.14% on his investment. That looks a lot better!

Closing thoughts The folks who taught me about note investing stressed that successful note investors only want to purchase 'happy-happy-happy' notes. That is, you're happy if the borrower pays as agreed, you're happy if they pay off the day after you purchase the note, and you're happy if you end up receiving the collateral instead of the payments in case the borrower doesn't pay. Clearly, the note as currently offered to John fails on the first two of those categories - negative ROI if paid as agreed, and buying the note for more than the amount currently owed. I didn't learn about the collateral, but failing two 'happies' means that I don't really care about the third - the deal would be a hard pass from my perspective. If John could pick up the note for $16.7K, then both of the first two criteria would be met (unless 39% is below John's target, in which case I'd consider buying it in his stead), and then he'd have to consider whether he'd be okay owning the collateral instead of getting the payments.

What do you think? Do you have any insight into note investing that I haven't covered here? How much would you offer for this note, assuming the collateral is worth at least the original $76,000 that was borrowed against it? Let us know in the comments!