This week we're going to buy a note at a discount!
If you want to know about paying down a mortgage, check out the last seven articles... we covered a lot!
One Two Three Four Five Six Seven
THE SCENARIO:
I've managed to save up $25,000 through frugal living, taking a second job, and selling some stuff on eBay. I want to do something smart with my money and increase my income even more without taking a third job. I've heard that buying promissory notes is a good way to do this, so I find a note broker, take a look at her inventory, and select one I want to purchase.
The note I purchase is a first mortgage on a house in Kentucky. The house is worth $45,000 and the borrower owes $41,500. The borrower (Bob) still owes 244 payments of $319.35 per month. After that point, he owns the home free and clear.
a) What's the interest rate on the loan?
b) How much equity does Bob have in the house?
c) What's my return on my $25,000 if Bob pays as agreed for the remaining life of the loan?
d) How much will Bob still owe on the loan two years from now if he makes all of his payments in the meantime?
e) If Bob refinances (paying me off in full) after two years, what's my return on my $25,000?
THE SOLUTION:
a) N is 244 (the number of payments remaning on the loan), PV is $41,500 (the amount Bob still owes), PMT is -$319.35 (the amount Bob has to pay each month), and FV is 0 (the loan amortizes fully). Solving for I/YR, I find that Bob's interest rate is 7.00%.
b) Bob's equity is the amount the house is worth minus the amount he owes. So $45,000 - $41,500 = $3,500 is Bob's equity in his house.
c) N is 244 (the number of payments I'm scheduled to receive from Bob), PV is -$25,000 (the amount I've paid for the note), PMT is $319.35 (the amount Bob pays me each month), and FV is 0 (the loan amortizes fully). Solving for I/YR, I find that my ROI is 14.51%. That's considerably better than my bank's offering these days!
d) N is 24 (2 years is 24 months, and I'm forecasting two years into the future), I/YR is 7.00%, PV is $41,500, and PMT is -$319.35. Solving for FV, I discover that Bob will still owe $39,515.84 in two years.
e) N is 24 (I get paid off after 2 years), PV is -$25,000, PMT is $319.35, and FV is $39,515.84 (the amount Bob pays me when he refinances his house). Solving for I/YR, I discover that my ROI for those two years is a whopping 35.64%. Sounds good to me!
DISCUSSION:
You may wonder why I chose 24 months as the time before Bob refinances. In truth, it was arbitrary, but I think it was possible, potentially even realistic.
The reason for this is that Bob's current interest rate is much higher than the norm today, so he has a big incentive to refinance his mortgage. Unfortunately for him, he's only got 7.78% equity in the house ($3,500 / $45,000 is 7.78%), so refinancing at really good rates will be tough.
If the value of the house appreciates even modestly over the next two years, however, and he continues to pay down the debt, it's entirely possible that he'll have 20% equity in the property by the end of two years.(I calculate 4.77% annual appreciation would do it - see if you can figure out how I got that number.)Since banks tend to give their best rates to borrowers with at least 20% equity, after two years, he may well be able to refinance and cut his interest rate in half. The Fed has signalled that low interest rates will persist for a number of years, yet, so this seems like a realistic scenario to me. Let me know what you think!
Well, that's it for this week! I hope you enjoyed the transition from mortgage paydown to owning the debt for a change! In the next few weeks, we'll explore the aspects of note ownership in greater depth.
See you then!
