Discount Mortgage Fundamentals

WHY & HOW PEOPLE SELL MORTGAGES A substantial number of Real Estate transactions are completed through owner financing or seller carry backs. This situation is where the seller, rather than a bank or other institutional lender, provides the financing for the purchase. Sellers provide this by the taking back a note, which is secured by the property. Often the seller will take a first lien, or priority position with respect to the property, although in some cases the seller may take a second lien position in order to complete the transaction. Many of the purchasers who require seller financing are qualified but have been unable to obtain institutional financing for a variety of reasons. The majority of seller-financed transactions are secured by residential properties; however, seller carry back financing is becoming more common with multi-family and commercial properties.

In many cases, individuals holding paper or notes would prefer to receive cash for their note, but they do not know how to accomplish this. Even individuals who wanted to carry notes on a long term basis may have events that occur in their lives which make it necessary, or desirable to sell their notes.  In response there has been an evolution of a secondary market for the resale of seller carry back financing.  

DISCOUNTING You may have heard of "discounted mortgages".  Buying a mortgage, trust deed or deed of trust for less than the face or present value is called buying at a discount.  Buying a note at discount provides a profit to investors, who pay cash today and wait to collect their money. The longer the investor has to wait to get his/her money back, the less they can pay today. 

INTEREST RATE is the cost of borrowing money. The higher the interest charged for the use of money, the higher the income it will produce.

TERM is the period of time it takes to pay off the note.

LTV is loan-to-value ratio. It is expressed as a percentage (%). LTV is defined as the sum total of all loans and other encumbrances against property divided by the market value of the property.

RISK involves many factors that revolve around the credit worthiness of the borrower and the property itself.

• borrower's general credit history
• total amount of  debt 
• borrower payment history
• ability to afford the payments
• job, salary and length of employment
• income level
• type of asset(s) that secure the debt

Whenever an investor pays cash today to receive cash at some future date, the Seller is asked to take a discount because time erodes the present value of the money.

PRESENT VALUE  Present value is the value of the future cash flows today.

Example: 

A seller of a mortgage note may sell the full amount, a fraction, or a portion of their interest in the mortgage note to an investor.  In order to make a profit, the investor requires a discount of the face or present value of the note.  The seller assigns the whole or a fraction of his interest of the remaining period of the mortgage note.  A document known as the assignment of interest spells out the terms and conditions involved in the transaction.  The investor calculates the present value of the future cash flows, discounts it, and the assignment document specifies the cash flows the purchaser of the note is buying. 

FUTURE VALUE The future value is the worth, at a specific point in the future, of an amount that is to be received or paid today.  Through the process of compounding, an investment will increase in value over time.   

COMPOUNDING  Compounding is the process of adding interest to the principal value over time and then adding interest on the increased amount so that the amount increases in value over time to some  future value.