What a business! The same skills we use every day to make a good living can also build our long-term net worth. Every deal and every note seller’s need is different, and developing creative solutions is what makes this business an art rather than a science. Every day offers chances to increase our net worth by staying in the deal.
Most people start in this business part time until they’ve proven they can support themselves. Once they have (or if they started with a nest egg), and after considerable experience, they begin to see many opportunities for future income or for building their estate.
How keeping the tail end pays you
A straightforward way to build wealth is to buy a full note and sell part of it to an investor, in effect keeping the tail end of the note. The note broker then benefits more than once during the life of the note:
- A transaction fee on the sale of the front end.
- A share of any early payoff. If the note prepays, your remainder interest has value. The payor pays off what he owes, the investor is paid what he is still owed, and you receive the difference.
- The remaining payments. If the note doesn’t pay off early, you receive every payment after the investor has received his contracted number of payments. Not a bad deal!
So a major question when choosing an investor for the front end is how that investor treats your remainder interest if the note pays off early. The difference in how investors treat your remainder interest can literally mean thousands of dollars to you. The issue is the investor’s prepayment policy.
The two camps of investor prepayment policy
A caution first: you must read and understand institutional investors’ partial purchase agreements. I’ve had institutional investors tell me they have no prepayment penalty, when in fact they expected to receive the payments they had bought calculated at the face rate of the note, not at their yield. If you’re not sure what that means, you will by the end of this lesson.
The best prepayment policy for a note broker is one where the investor gets back only the unamortized principal of his investment. You can arrange this with private investors, and with some institutional investors once you have experience and exposure in the industry. In the beginning, you’re more likely to meet investors who want an additional fee if the note pays off early.
Institutional investors tend to fall into one of two camps when they calculate what they’re owed on a partial after an early payoff:
- A percentage penalty. They charge 5% to 12% on top of their remaining unamortized principal.
- A B schedule. They must be paid the present value of the payments still due to them, calculated at the face rate of the note (not the investor’s yield).
In the two case studies below, we buy a full note, sell a partial income stream and keep the tail end. To keep things simple, both investors require the same yield (highly unlikely in real life). If the note pays off before the investor receives all his payments, Investor #1 receives 105% of his unamortized principal balance, and Investor #2 receives the present value of the payments due to him at the face rate of the note.
