Are private notes for you?

The financial community has been through some pretty tough times in recent years and many traditional lenders are finding any excuse NOT to make loans. Often they will try to write an A paper deal at B or C paper rates and if the principles agree to it, they make the deal. The terms the lender will offer are often well below what they historically would have done. This means that the lender will offer, say, a 10% interest rate where previously it would have offered a 6% rate, or offer to finance 70% of a purchase where it would previously have financed 90%. You’ve probably heard this on the news where good, solid buyers can’t get bank loans for their businesses or to buy houses or cars or whatever. Financial markets are tight. However, people still need cash to buy houses, cars and items for their businesses, so they have turned to the private market to meet their financial needs. Even in the best of times, 90% of all financing for small business sales has been seller return financing.

Once these notes or paper have been created, the beneficiary (usually the seller) receives monthly payments that include principal and interest on the amount they financed for the buyer or payer. Since these note holders are individuals and not financial institutions, there is a limit to the amount of their principal that they can have tied up in these financial instruments. They often need to free up this cash and sell the tickets so they can make other deals or buy other equipment, cars or houses etc. They need a buyer who will pay them the cash balance of the amounts still owed to them or as close to this balance as possible. Typically these buyers of this paper demand a higher return on their investment than the demand of institutional financial companies.

For example, if the prevailing FNMA mortgage rate on a first mortgage is 5% fixed for 30 years, a private investor could demand and earn a 10% return on their invested principal. Since once the note is created and the terms of the note (interest rate, term, etc.) have been established, it cannot be changed. The way the note investor gets their return from 10% on paper to 5% is by discounting. This means that the buyer of the note will only pay, say, $80,000 for the remaining balance of $100,000. This is a difference of $20,000 or 20%. This difference is the discount. There is nothing magical about this 20% and it fluctuates up and down depending on many variables in the transaction such as: collateral type, nominal interest rate, remaining term, owner-occupied or not, payment history, profile of the buyer/payer, etc. It is safer and better to have the underwriting of all these variables or due diligence as it is called done by a professional firm.

Thanks for your time,

TJ Stewart, Founder and CEO