It’s very hard to buy a note from someone who doesn’t understand the time value of money, no matter what you tell him. Most people can’t see why they shouldn’t get $10,000 for their $10,000 mortgage.
“After all,” he might say, “it says $10,000 right on it.” Since you’re telling him he’ll end up taking less than what he thinks is fair, many note holders just won’t trust you. Here are two approaches that work in many cases.
The $10 now or $100 later test
Offer him a choice: a $10 bill right now (have the bill right in front of him) or a $100 bill six months from now. Most people will choose the $100 in six months.
Then ask, “How about $10 now or $100 a year from now?” If he still picks the $100, keep stretching the time until he chooses to take the $10 now.
Your response:
“Congratulations! You now understand the time value of money. Actually, you understood it all along. We all do; most of us just haven’t put that name to it. You’ve told me that a $10 bill now is worth more than a $100 bill two years from now. So the important factor isn’t the amount printed on the piece of paper, whether it’s a bill or a note. It’s when you get the money.”
The lottery comparison
A reader who brokers lawsuit settlements, lottery winnings, and mortgage and business notes uses this approach the first time he talks with a potential seller, usually on the phone:
I ask them if they play the pick-6 lottery. Most people do, or have at some time. Here in New Jersey, the ticket buyer has the choice of a cash payout or the 20- to 25-year payout (annuity). The lottery machines have a scrolling display that usually shows the current pick-6 jackpot both as an annuity and as a lump sum. The lump sum is roughly 50% of the annuity value.
I tell the note holder that the present value of those 20 to 25 years of payments is only about 50 cents on the dollar today, and that’s about what my investors would pay a new pick-6 winner for all remaining payments. I’d give more cash now for next year’s payment than for the payment the year after, and more for that one than the one after it. Maybe next year’s payment is worth 95 cents on the dollar, but year 20’s payment is worth only 10 cents today. Add up what I’d pay for each of the next 20 years and it comes to about 50% overall.
Inflation makes future dollars worth less
Next he brings up inflation:
$100 today may buy 100 loaves of bread, but in 10 years, when that payment comes due, the same $100 may buy only 75 loaves, or 50, or who knows? The future payment comes in cheaper dollars with less buying power. So I won’t pay $100 now for $100 later. Any money coming due in the future is worth less than face value today because of inflation and compounding.
Answering the seller’s next question
The next question you may get is, “How do you calculate the present value of future money?” It depends on the source of the payments and what the buyer wants to earn on the investment. The amounts and dates go into the calculator, and out comes a purchase price for the income stream.
If he knows the approximate yield his investors want, he can give the caller a rough figure from his calculator on a simple income stream such as a mortgage note. Otherwise he gets back to them after reaching his investors. Either way, the point is to prepare the seller for the real quote and avoid sticker shock later. As he puts it, if he can’t teach the caller the time value of money right away, he probably won’t have a deal when the quotes come in.
He also asks how much money the seller is looking for, so he knows whether it’s reasonable and whether the deal is worth pursuing.
