How to answer “What’s your discount?” and “What yield are you getting?” by showing the seller his own return on the balloon.
By W. J. Mencarow · 6 min read · Lesson 4.14
“What’s your discount?” “What yield are you getting?” “Why is the total of all the payments you’ll receive so much more than what you’re offering me?”
Yikes! Here’s a way to deal with those pesky questions. I’m grateful to Del Ashby for the original idea and the inspiration to develop it.
Buy the payments, leave the balloon
Suppose you find a $50,000 first mortgage at 8%, amortized over 30 years, with a balloon due in five years. In the tables, N is the number of monthly payments, I the annual rate, PMT the payment, PV the present value and FV the balloon.
N
I
PMT
PV
FV
60
8%
$366.88
$50,000
$47,535
You don’t want to bet on whether the balloon gets paid when due, so you let the note holder keep that risk. You offer to buy the next 60 payments and let him keep the balloon. You want a 14% yield, so you offer $15,767:
N
I
PMT
PV
FV
60
14%
$366.88
$15,767
$0
Worked example: the seller’s return on what he leaves in
Suppose the seller says, “You’re asking me to give up the interest on my money for five years!” You could answer, “No, I’m giving you $15,767.” But you can make that answer better.
Subtract the $15,767 you’re paying from the $50,000 balance. The $34,233 left is what he still has invested in the note. Here’s his return on that $34,233 when he receives the $47,535 balloon in five years:
N
I
PMT
PV
FV
60
6.58%
$0
$34,233
$47,535
Collecting the balloon earns the seller 6.58% on the money he leaves in.
Turning his return into your answer
That 6.58% is a very important number. Use it to defuse questions about your discount, your yield, or why the payments total more than what you’re offering. Your answer to all of them: “Currently our company’s discount rate is 5.7% for each year our funds are tied up.”
The seller is getting over 6.5% on his money. Your discount rate is 5.7%. Is that fair?
Why the apples-to-oranges answer works
Yes, it’s apples and oranges. But so is the seller’s comparison when he adds up all the payments and compares the total with your offer. That’s a make-or-break point in a note negotiation. Once it occurs to him (or his spouse, his lawyer or his banker) to multiply the number of payments by the payment amount, he’s comparing apples to oranges, and he won’t listen when you tell him so.
If he objects that your comparison isn’t equivalent, he understands present value, and he never should have compared the gross total of the payments with the present value in the first place. If he tries to argue both sides, point out that he ignores present value when it suits him and suddenly knows all about it when it doesn’t. There has to be a level playing field. Either you both talk present value or you play games.
Changing the focus, not deceiving
Most note holders (like almost all spouses, lawyers and bankers) know nothing about the time value of money and aren’t interested in hearing about it. You won’t break through that wall, so instead of trying to educate him, change the focus of the negotiation:
“You’re getting over 6.5% a year. I’m asking for a discount of 5.7% a year. Is that fair?”
The goal is never to deceive him. It’s to move his focus away from the gross total of the payments, which is meaningless from a time value of money standpoint, and toward the facts: if he accepts, he gets $15,767 in cash now and almost the same return on his money as if he kept the note (8% versus 6.5%). The “discount” works out to 1.5% a year. And he still gets the entire $47,535 balloon.
Quick guide to the three tough questions
Here’s the approach from this lesson boiled down to a one-page reference. Keep it next to the phone.
The seller asks
What’s really going on
Where to steer the conversation
“What’s your discount?”
He’s focused on the gap between the balance and your offer.
His own return on the money he leaves in the note: over 6.5% a year in the example.
“What yield are you getting?”
He suspects you’re getting a better deal than he is.
Compare his yearly return with your yearly discount rate, not your yield.
“Why do the payments add up to more than your offer?”
He’s adding up future dollars as if they were today’s dollars.
Explain that money received later is worth less today, then return to his return on the balloon.
Work the numbers for your own deal before the call. The approach only works if you can state the seller’s return with confidence. You can run each step with the note calculator.
Mistakes to avoid with this approach
Using numbers you haven’t checked. Get the seller’s return on the balloon right before you quote it. A wrong figure destroys trust fast.
Using it to mislead. As the lesson says, the goal is to change the focus, never to deceive. If the seller wants a full explanation of present value, give it.
Arguing instead of asking. Ask whether the comparison seems fair, then let the seller answer.
Forgetting the balloon risk. In a partial purchase, the seller keeps the balloon. Make sure he understands that he’s still the one waiting for it.
