Seller Financing & The Future Value of Money...

The Future Value of Money (FVM) is a concept of which many people are unaware. Simply put, the FVM means today's dollars are worth more shall future dollars.

This is one of the reasons why notes with longer terms are discounted more than short-term notes. The reasoning behind the FVM is twofold.

The first reason is inflation. Inflation will drive the value of the dollar down over time. The same two dollars that will buy a loaf of bread today will not buy a loaf of bread ten years from now. Likewise, how many loaves of bread would two dollars have purchased twenty years ago?

The second reason is a sort of almost opportunity cost. Money currently tied up in an investment is unavailable for another investment. This is also affected by the length of time of the commitment. The example below will explain this further.

Let's look at a few examples using interest compounded monthly. We will calculate the value of $ 1 000 in ten years if we invest it at 5%:

• Investment: $1,000.00
• Interest: 5.00%
• Time: 10 years
• Final Value: $1,647.01

Using this example we can reverse the calculation to discount for the FVM. If today someone was to offer to sell to you a one-time payment of $1647.01 in ten years from now, and you feel that you should earn 5% on your money, then you would offer that person $1,000.00 today for that future payment.

Now your $1,000.00 is unavailable to you for ten years while it is earning 5% interest. If someone was to offer you an investment opportunity at 12% interest, you no longer have that $1,000.00 to invest (hopefully you have other money available).

Let's continue with the above scenario, but this time you know that you can make a 12% "yield'' on your money elsewhere. Therefore, when you are offered the one-time future payment of $ 1,674.01, you know that to make it worth your while you need to make more than 12% on your money. For this investment, you want to make 15% also on your money.

• Future Payment: $1 647.01
• Interest: 15%
• Time: 10 Years
• Value in Today's Dollars: $370.93

That is quite a difference from the value of the future payment at 5%. This is the Future Value of Money at work, and is one of the reasons why notes are discounted when purchased by note investors.

Investors target a desired "yield" when making an offer on notes, because they know that they can make that same yield (at relatively the same level of risk) elsewhere.

This yield is based on many different factors, but in general is based on the unperceived "risk" of the investment.

Now let's look at a fully-amortizing note and discount a few individual monthly payments to see how the FVM increases the discount the farther into the future we go. For this example, we'll say that we want to make 12% on our money:

• Face Value: $150,000.00
• Interest: 6%
• Term: 30 years
• Yield: 12%
• Monthly Payment: $899.33
• At Payment #60: $495.04 Value in Today's Dollars
• At Payment #120: $272.49 Value in Today's Dollars
• At Payment #240: $ 82.56 Value in Today's Dollars
• At Payment #360: $ 25.02 Value in Today's Dollars

Here you can see how the FVM decreases the value of payments further as the length of time increases. A roughly $900.00 payment 30 years into the future is worth only a little over $25 to someone who can make 12% on their money.

This is why the discount is steeper on the long-term notes; the last few years of payments are so far into the future, the FVM reduces their value dramatically.

Using a different scenario, let's take a payment stream of $500 per month and compare the amounts offered for 15 years and for 30 years of payments at the same 8% yield:

• 15 Year Term: Future Value: $52,320.30
• 30 Tear Term: Future Value: $68,141.75

The difference between a 15-year and 30-year term only yields an additional $15,821.45.

You can see that doubling the amount of payments adds only about 30% to the value of the cash flow stream. This is because those particular payments do not begin for another 15 years, and the Future Value of Money discounts them much more than the first 15 years of monthly payments.

To discuss the Future Value of your seller financed note, call us toll free at 1-800-349-6119.