Every now and then a note seller offers a note that is due all at once, with no installment payments. Such notes usually come out of a divorce or a building project. Before you price one, there is a question you need to ask first.
Why some notes have no payments
A note comes due all at once because the payor can’t afford to make payments. Sometimes they have another mortgage to pay off first. Often they must sell the property to raise the money to pay off the no-payment note.
The most common case is a divorce. The wife gets the house, the first mortgage payments and the kids. The husband gets an interest-bearing note signed by the wife and secured by the house.
The wife can barely afford the first mortgage, and certainly can’t afford payments on a note to her husband. So the husband takes a note with no monthly payments, with the full principal plus interest due in five years. That gives the wife time to sell the house while she still lives in it.
Two correct answers to the same note
At the end of five years, the wife sells the house and expects to pay her husband an amount she has worked out by hand. The husband says it isn’t enough. His financial calculator shows a bigger number.
They have run into the most common problem with notes that go more than a year without a payment: nobody agreed whether the interest is simple or compounded annually.
- The wife used simple interest. She calculated interest on the principal amount of the note only.
- The husband used his financial calculator, which adds each year’s accrued interest to the balance. In year two he is charging interest on interest plus principal, and so on for the whole term. That is annual compounding, and it produced a much larger number.
Both amounts are mathematically correct. Only one of them applies to the note, and the parties never agreed which.
The problem comes up because no one thinks about it. Financial calculators compound annually by default, so it is easy to punch in a few numbers and assume the note matches the calculator.
Ask the seller, then the payor
One of the first questions a note buyer must ask a note seller is: “How is the interest calculated, simple or compounded annually?” The usual answer is “I don’t know. What does compounded annually mean?”
Once it’s explained, most sellers say they’d prefer compounded interest, because they want as much money as possible. When you contact the payor, the answer is usually “simple interest,” because payors want to pay as little as possible.
Read the face of the note
Most no-payment notes don’t say the interest compounds. They say something like “Interest shall accrue at 12% per annum” and nothing more. That vagueness leads to serious disputes that can end up in court.
To avoid the mess, make sure the method of computing interest is clearly stated on the face of the note. If the note doesn’t say interest is compounded annually, a prudent buyer assumes simple interest. A payor will almost never agree to pay compounded interest the note doesn’t spell out.
The parties could sign an amendment that specifies annual compounding, but it is very unlikely. Without one, count only on simple interest.
Never assume your calculator’s programming gives the same answer as the face of the note. The rule is: always ask.
