Have you ever wondered how car manufacturers can make a profit by offering 0% financing to car buyers? It is a simple reverse calculation of the required note discount to determine how to set a Present Value (PV) for the note purchase. The car buyer can choose to pay a higher price for easy financing terms or to pay a lower cash price.
There are three parties to the transaction: (1) The seller, (2) the buyer, (3) the financier. The seller wants to receive a lump sum of $10,000 at the closing of the sale. The buyer wants 0% financing for, say, 60 months (5 years), fully amortizing. The financier wants to earn an annual yield of 10%.
Using your financial calculator, set the Future Value (FV) to zero (this is a fully amortizing note), set the term to 60 months, set the annual interest rate to 10%, set the Present Value (PV) to $10,000. Now calculate the monthly (periodic) payment. You have calculated the required payment stream to earn an annual yield of 10% on a $10,000 investment. (If the buyer is paying a down payment, then subtract that amount from the $10,000 to calculate the amount that is financed.)
Now set the annual interest rate to 0% and calculate the new PV (about $12,748 in this example). You have recast the note with front-loaded interest into a straight note with back-loaded interest and periodic principal-only payments.
The seller receives a note and security instrument from the buyer (no prepayment penalty). The note has the principal balance of $12,748 with 60 equal monthly principal-only payments. The buyer receives title at the closing. The seller immediately sells the note and the security instrument to the financier for $10,000 cash. The seller has his required cash, the buyer has purchased for 0% interest financing, and the financier has his 10% yield cash flow note. Everyone is happy. By the way, calculate the financier’s actual yield for an early pay off after 30 months. The early repayment actually increases the financier’s yield to 13.1%.
By altering the dollars and percentages, you can apply this simple principle to financing real estate transactions as either a buyer or seller or financier. I suggest that when you sell on terms, that you try to negotiate as large of a down payment as the buyer can afford (or structure the transaction with multiple notes and varying amortization terms), so that the financier that buys your note is secured by sufficient protective equity in the collateral.