WHY DO PEOPLE SELL NOTES?
(This section is an exerpt from the Note Holder's Handbook.)
SELLING A NOTE
Perhaps the most common reason people seek to sell their notes is to eliminate risk. Throughout this handbook we've discussed many of the potential hazards for note holders. These hazards have one thing in common: should something go wrong, note holders risk losing part or all of the remaining balance on their note. Most people don't understand the risks simply because they were never explained to them. Often people are talked into holding a note by the property purchaser or a realtor looking to close a sale. Usually neither the purchaser nor realtor themselves really understands the risks they are asking the potential note holder to take. This lack of knowledge by all parties is understandable, however, since this is a very specialized area of financing and information regarding the risks has not readily been available in a comprehensive form, until now. At Cascade Funding, Inc. our business is purchasing and holding notes. We've gained a thorough understanding of the risks through years of hands-on experience. We've seen and experienced very unfortunate situations regarding holding notes as investments and we spend a great deal of time helping note holders, realtors, mortgage brokers, and attorneys understand the risks for themselves and their clients. By following the suggestions in this handbook, many of the risks can be lessened to a degree, but certainly not eliminated. As mentioned previously, you as a note holder have some major responsibilities in protecting your investment. Many people do not wish to assume these responsibilities and therefore, seek to sell their note. If you are risk averse, and don't wish to assume the responsibilities to lessen the risk, then selling your note may be a good option for you.
Another very common reason people sell their notes is to achieve liquidity. This means they wish to have access to the large sum of cash they would receive. When you hold a note, you only have the right to receive small monthly payments. You can't spend the principal balance. Most people wish to have the large sum of cash for three reasons: 1. To take advantage of other investment opportunities; 2. To pay off debts; and, 3. To make specific purchases.
Other Investment Opportunities
If you're receiving small monthly payments, there's not much you can do with your note should another investment opportunity present itself. Other investments usually require a significant amount of cash outlay. From your real estate note, about the only way this can be accomplished is to sell the note for a lump sum. Sometimes you can borrow against the note, but that's rare. It also puts you at even greater risk because if your payor stops paying, you have no money coming in to make payments on the loan you received. Anyway, other investment opportunities can be almost anything, even as simple as placing the cash in a bank account or Certificate of Deposit (CD). You should understand that the interest rate on a real estate note is not comparable to that earned on savings accounts or CDs. Real estate notes earn SIMPLE interest; bank accounts and CDs earn COMPOUND interest.
Let's quickly look at an example that compares carrying a real estate note full term, with a 5% interest rate, to selling that note and placing the lump sum of cash in a CD earning just 3% interest (Update: as of 12/15/2022, 3 - 9 month brokered CDs are earning 4% - 5%!):
Suppose you agreed to carry financing on the sale of your home. The note you and the buyer agree to is for $94,500 at 5.0 % for 30 years with monthly payments of $507.30. This investment could generate a very nice retirement "nest egg," but only if you are able to save all of the payments when they are received. Unfortunately, most people spend this money as it comes in each month, usually on mundane items like the electric bill, car payments, or the cable TV bill. Sadly, after years of collecting all of those monthly payments, they have nothing to show for their investment.
Assume you sold this note for $80,000 which you then placed in a Certificate of Deposit that earns interest at an average rate of just 3%. Unlike small monthly payments, people are much more inclined to invest a large sum of money than to spend it. Let's look at both situations now:
1. If you were to collect all your monthly payments, the total cash you would receive after 30 years would be $298,552 as illustrated below:
End of Year Liquid Cash
1 $ 6,088 ($507.30 x 12 months)
30 $182,628 ($507.30 x 360 months)
2. Now, let's see what $80,000 invested today at 3% would yield over the same 30-year period:
End of Year Liquid Cash
1 $ 82,433
You would earn nearly $13,190 more with the $80,000 invested at just 3% than if you collected all the note payments (at 5%) over the same 30-year period. The reason for this is simple: compound interest. It's worth repeating: A real estate note earns only simple interest on a declining balance; when you invest this large sum of money you'll earn compound interest on an increasing balance. That's interest earned on both the principal and the interest you're receiving on this large sum of money. Factor in the much greater risk associated with holding a real estate note and the value of investing the $80,000 today becomes even more attractive. When your money is invested in a bank account, you have the ability to use the balance for anything you choose, any time you choose (i.e., you have liquidity).
The bottom line is that selling this $94,500 note for $80,000 (a $14,500 discount) and investing the $80,000 today earns much more over the life of the note than the sum total of all payments to be received, with zero risk, and full ability to use the money should you wish to.
These are real world numbers. Some people just can't get over the fact that they have to take a $14,500 discount on their note. This is shortsighted thinking and the reason most people do not achieve financial security in their lives. However, once a comparison of this kind is done, most people see the real advantages of selling their future payments. Most people who sell their notes for alternate investments, however, don't just put their money into the bank. Usually, they do so to take advantage of investments with higher yields. Imagine what the numbers above would look like if you could invest the $80,000 in something that earned 12% (instead of 3%) compound interest!
Pay Off Debts
Another very common reason for selling real estate notes is to pay off debts. Usually, people seek to pay off high interest bearing, revolving charge cards. Others use the money to pay back taxes or capital gains taxes. And still others wish to pay off their car loans to finally own their vehicle free and clear.
Make Specific Purchases
We often hear from note sellers that they wish to have the large sum of cash to buy certain items they otherwise couldn't get, or would have to go into debt to get. These include vacations, college tuition for their children, cars, boats, a house, start a business, you name it. The sale of their note is often the only way they ever would be able to generate enough cash to make these purchases.
At the time of this edition (February 2022), interest rates are still at historical lows. This means that the cost of capital for note investors is very low, and this translates to the greatest amount of cash offered for real estate notes ever. When interest rates are at all time lows, the reasonable expectation is that they will not stay at these levels -- they will most certainly rise, perhaps significantly, in the near future. This will mean that interest rates on savings accounts, CDs, and so on, will also rise. Recall the example earlier comparing holding a 30-year, 5% note with investing in a 3 % CD. Imagine if interest on CDs climbed to 8%, 9%, or higher. It's a plausible scenario over the next 30 years. It's certainly more likely than to expect interest rates to decrease. Now consider the 30-year real estate note. Its simple interest rate of 5% will never change no matter what happens in the economy. Therefore, the very low interest rate environment right now offers many note holders these two compelling reasons to sell their notes: 1. To take advantage of the greatest amount of cash most investors have ever offered, and perhaps ever will offer, when purchasing notes; and, 2. To invest the lump sum of cash in interest sensitive investments to take advantage of the greater probability that interest rates will not remain at their current low levels much longer.
Many people sell their property and then move out of state. It's especially difficult to service your note if you're out of state, not to mention what you'd have to do if your payor stopped paying. Many people just want to be rid of the anxiety of being an out of state lender. Selling their note is the only way for them to get the fair market, present day value for their note and be done with the property altogether.
Notes are frequently created as equity settlements in divorces. The beneficiary of these notes often wants no more to do with their ex-spouse, especially if the divorce was an unpleasant one. Selling these notes often presents the perfect solution in these cases.
See the discussion here for further information.