What is a Discounted Note?
A note is simply an IOU. A payor has promised to pay someone else, called a beneficiary, some money. The payor may agree to pay interest on the money, and to pay part of it back in daily, weekly, monthly, yearly installments or in one lump sum in the future. We, as note buyers, will buy that IOU from the beneficiary (i.e. the person receiving the payments) for a lump sum of cash now. How much we will pay depends on the discount we can convince the beneficiary to take from the face amount of the note.
The discount we would demand from the face value of the note depends primarily on two factors:
- How safe is the note? If the note is merely an IOU from an unemployed drug addict, we would demand a very, very steep discount. If the note is from a wealthy person, and if the note is secured by some kind of collateral we might not demand a very large discount. The collateral that insures the note will be paid can be a car, furniture, anything of value or real estate. If it is real estate, the note will be backed up by another document called a Trust Deed, a Mortgage, a Land Contract, or some other instrument of hypothecation. We would feel the note is safe if the real estate or other property had a value that was larger than the value of the note.
- What are current interest rates for other investments? If the interest rates are high on bank loans, savings accounts and T-bills, then we would demand a higher discount than if interest rates were low. For example, if someone had a loan written at 10% interest, I would offer to buy it at one price if T-Bill rates were 9%. If T-Bill rates went to 20%, I would have to offer a lower price for that 10% note. The higher the T-Bill rate the less a note may be worth.
A note is really an income stream running into the future. The person who is receiving that income stream, the beneficiary, may find that he or she does not want the income stream, but wants or needs a lump sum of cash now. The only thing that can buy that income stream at a discount is CASH now. That is the heart of the discounted note industry. You will need to understand how to use a financial calculator. Feel free to go back to the home page and down load further information.