Time Value of Money, The Theory Behind The Discounting of Promissory Notes

Any discussion about the Time Value of money requires an understanding of the basic psychology of discounting notes:

Which would you prefer - the $500 in my left hand or the $1,000 in my right hand? That is pretty easy. The $1,000 in my right hand of course.


What if you had to wait seven years for the $1,000, but you could have the $500 right now? All things considered you would probably take the $500, right? That is an example of how "time changes things".

This is a very simple example of the time value of money. Just remember, money today is much more valuable than money at some time in the future.

Note holders are driven by the same motivations. How much they are willing to discount depends entirely on their individual circumstances. Depending on their situation people are often willing to discount from 50% to 90% on problem notes.

Wow. That is quite a discount range. Here are just a few of the reasons note holders are willing to discount their notes:

Opportunity costs - they can make more money on other investments if they have the money from their note right now.

Cash now vs. cash later - simply compare the benefit and appeal of a lump sum of cash now to a much smaller cash flow over time.

Late payments - too many late payments diminish the value of the note. A non-performing note results in a much larger discount than a performing note.

Location of the collateral - location of the property is of paramount concern. Time and area trends contribute to the ebb and flow of property and note values.

Terms of the note - the interest rate, time, balloon payments if any, the original down payment on the note, and the credit of the borrowers play a big role in their willingness to discount their note. One of the most important factors in establishing the time value of money is the amount of time it will take to collect all of the payments. The longer the time period, the less value the note has because of inflation and other economic considerations.

In other words, time to collect money reflects the Time Value of Money. Money today is much more valuable than money to be received at some time in the future.

This is just a short list of some of the reasons a note holder is willing to discount, and how much he or she is motivated to sell. It depends on the situation.

The actual value of money is determined by the interest rate you can earn at that time. To illustrate, here is another example.

You just won a $10,000,000 lottery. The state will pay you monthly over twenty years. You contact me about selling your payments because you need $2,000,000 cash right now.

We evaluate the deal which includes your needs, and our investment guidelines. We make an offer of $2,699,822 for your stream of payments. You get what you want, $2,000,000 in cash right now, plus a bonus of $699,822! We got what we wanted, a satisfied client, a high quality note, and an acceptable return on our investment. We both got what we wanted. That's the way our transactions should be done, a win-win for all involved.

This is a great example of the time value of money. With the time value of money, discounting of the note involves the application of the investor's desired yield or interest rate to the payment stream remaining on the note. We work these numbers to determine the actual value of the cash flow today. The yield/interest requirements are determined by the investor, economic conditions, and a host of other selection criteria.

Just remember, when dealing with a stream of payments or cash flows, cash today is always more valuable than cash at some time in the future.

Insider Tip
Don't concern yourself wth the investor's yield. The overall yield requirements are determined by a number of complex criteria. Be assured that the amount of money you need is the most important concern, because all criteria are evaluated and structured to get the money you need. Our professional motivation and purpose is to create win-win-win solutions.

When you add the impact of inflation on your dollars the significance of this fact of financial life is magnified even more. For example, remember when a gallon of gas was only 22 cents? Well I do! Now gas is closer to $2.20 or more depending on the economic ebb and flow. That means it costs ten times and more for a gallon of gas today than it did back in the 1960's! That is a dramatic loss in purchasing power. The point? Cash now is much better than cash later.