For years there has been confusion about both compounding
and discounting. It was actually simpler
before calculators came along. Formulas are built
into the calculators and choices had to be made.
I've always wanted to talk to one of the people
that developed the formulas. He's a friend, but a
little too thrilled with his own accomplishments
to be questioned in this area. As the old saying
goes, "he has a mind like a
steel trap  rusted shut". I
did really get a kick out of it one day when he
was disagreeing about the value of some notes. I
enjoyed showing him the correct numbers on the
calculator and then saying something like, "I
guess it's right, you did program the formulas
didn't you?"
The confusion comes in the compounding/discounting
period or periodic rate. If you want to calculate
an annual yield , discount or compound a note
that is a lump sum payment, you have to jump
through some extra hoops to get a correct answer.
Technically, the calculator is wrong. You tell
it you want to discount to an 18% yield on a lump
sum payment and it turns around and discounts at
a periodic rate of 1.5% per month. On the
surface, it sounds the same, but it isn't. 15
years at 18% and 180 months at 1.5% are not the
same.
Your answer would be more correct when you are
using the 15 years and one payment a year. I've
always done it that way. I like to be precise. If
it's 18% annual yield on a
balloon, then that is what I want to see. A
1.5% periodic rate is different. First
let s look at compounding. You may run into this
any time you pay off a loan. It can make a
substantial difference financially.
For example:
If I take a $10,000 note with
no payments and a balloon in 5 years
at 10% interest, it would be 15,000
total if it were simple interest. I like to write
notes I pay that way. The rate of 10% on a
balance of $10,000 is $1,000
times 5 years. Few notes are
written that way. The wording would be "bearing
interest at 10% simple interest"
A normal note is compounded
annually if it does not say otherwise.
Annual compounding achieves $16,105.10,
because each year there is interest on the
previously accrued interest. Interest is
compounded annually unless it states otherwise.
Title companies, mortgage companies, real
estate agents and others will constantly try to
charge you more because they do not understand
the principle. In one of my seminars I was asked
the question "John, why don't bankers invest
in notes?" A banker going through my seminar
volunteered the answer. "John, if a
banker has a financial calculator on his desk 
it s a paper weight." I have to
straighten out their ignorance quite often.
Sometimes it makes thousands of dollars of
difference in the payoff of a loan.
So, if you re paying on this $10,000 note
and are ready to pay it off in 5 years, you owe $16,105.10.
Someone may try to charge you $16,453.09
by compounding the amount monthly. That s a 10.47%
interest rate  not 10%. Here s
the numbers.
N

I

PV

PMT

FV

5

10

10,000

0

16,105.10

60

1.5

10,000

0

16,453.09

The same person is likely to discount in the
same manner. Let s take the true balloon amount
of $16,105.10 as an example. If
I want an 18% yield, I would pay
$7,039.69. Most people will
calculate a value of $6,591.75,
because they will use a periodic rate of 1.5%
and 60 months instead of an
annual rate of 18% and 5
years.
N

I

PV

PMT

FV

5

18

7,039.69

0

16,105.10

60

1.5

6,591.75

0

16,105.10

The true yield on the note would be 19.56%
if you paid $6,591.75.
That may seem all right if someone intends to
just be a bird dog and point to notes for
commissions (a milk bone?) for the rest of their
existence. Actually, the calculator and the time
value of money have always been an entrance
barrier that keeps people away from funding or
investing in notes.
Over the last 20 years, the
sophistication and expertise of this industry has
steadily declined. Fewer and fewer
people have a working knowledge of the calculator.
Probably 100 times as many people are in
the industry with one tenth the experience.
Years ago I used to work hard to teach people
this. In fact, the examples in "The
Paper Game" and earlier
books show the more precise methods. My more
recent writings show the more common (but flawed)
methods, because I get tired of trying to swim up
stream  even if it is the right direction.
The greatest profits available in almost any
form of investment are available by OWNING notes
 not just being a broker. Brokering
notes is a job. Buying notes is an
investment that I know nothing that even compares
to it in both safety and profitability. What it
takes is creativity, the ability to fund notes
and a solid knowledge of the basics. None of
which can happen within the time period of a few
days.
The nice thing about note investment is that it
can be a great job as you learn to invest. Even
better is the fact that you can be paid as
handsomely to invest in notes as you are paid to
broker them. I always profit when I buy the note
as much or more than someone who brokers it. Best
of luck!
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