DISCOUNTING A MORTGAGE

Overview

Promissory notes are a common financial instrument in many jurisdictions, employed principally for short time financing of companies. Often, the seller or provider of a service is not paid upfront by the buyer (usually, another company), but within a period of time, the length of which has been agreed upon by both the seller and the buyer. The reasons for this may vary; historically, many companies used to balance their books and execute payments and debts at the end of each week or tax month; any product bought before that time would be paid only then. Depending on the jurisdiction, this deferred payment period can be regulated by law; in other countries .

When a company engages in many of such transactions, for instance by having provided services to many customers all of whom then deferred their payment, it is possible that the company may be owed enough money that its own liquidity position (i.e., the amount of cash it holds) is hampered, and finds itself unable to honour their own debts, despite the fact that by the books, the company remains solvent. In those cases, the company has the option of asking the bank for a short term loan, or using any other such short term financial arrangements to avoid insolvency. However, in jurisdictions where promissory notes are commonplace, the company (called the payee or lender) can ask one of its debtors (called the maker, borrower or payor) to accept a promissory note, whereby the maker signs a legally binding agreement to honour the amount established in the promissory note (usually, part or all its debt) within the agreed period of time The lender can then take the promissory note to a financial institution (usually a bank, albeit this could also be a private person, or another company), that will exchange the promissory note for cash; usually, the promissory note is cashed in for the amount established in the promissory note, less a small discount. Once the promissory note reaches its maturity date, its current holder (the bank) can execute it over the emitter of the note (the debtor), who would have to pay the bank the amount promised in the note. If the maker fails to pay, however, the bank retains the right to go to the company that cashed the promissory note in, and demand payment. In the case of unsecured promissory notes, the lender accepts the promissory note based solely on the maker’s ability to repay; if the maker fails to pay, the lender must honour the debt to the bank. In the case of a secured promissory note, the lender accepts the promissory note based on the maker’s ability to repay, but the note is secured by a thing of value; if the maker fails to pay and the bank reclaims payment, the lender has the right to execute the security

Thus, promissory notes can work as a form of private money. In the past, particularly during the 19th century, their widespread and unregulated use was a source of great risk for banks and private financiers, who would often face the insolvency of both debtors, or simply be scammed by both.

The terms of a note usually include the principal amount, the interest rate if any, the parties, the date, the terms of repayment (which could include interest) and the maturity date. Sometimes, provisions are included concerning the payee’s rights in the event of a default, which may include foreclosure of the maker’s assets. Demand promissory notes are notes that do not carry a specific maturity date, but are due on demand of the lender. Usually the lender will only give the borrower a few days’ notice before the payment is due. For loans between individuals, writing and signing a promissory note are often instrumental for tax and record keeping. A promissory note alone is typically unsecured but these may be used in combination with security agreements such as mortgage, in which case they are called mortgage notes.

DISCOUNTING MORTGAGES

Buying for less than the face value is called buying at a discount. You may have encountered a term like “discounted mortgages” and wondered what was meant .

This is it:

If a note cannot sell  at a discount there is no profit and no reason to buy.

From the lenders point of view the time value of money states that by paying cash tomorrow, the lender has to get a discount because they have to wait to collect their money.  The longer the lender has to wait to get his/her money back, the less they can pay today.

The cash is the sale of he paper (note) at a reduced price to enable the lender to have an overall yield greater than the contract rate on the mortgage.  This cash sale of paper can occur at any time after the mortgage is written and up until the date due is satisfied.  A mortgage which has some maturity is considered to have a performance record, and hence may be discounted less than if it had no record of payments.  Mortgages discounted in the early years will generally have a additional penalty for this lack of what is called (seasoning) of the note.  This will depend on the type of mortgage and the position of rank .  It is obvious that a second mortgage will not be as saleable as a first mortgage on the same property.  Therefor , it may require a greater discount.

Discounting is the reverse of compounding  but many people have a hard time understanding this.  Using our bond example (time value of money) when we bought a $100.00 bond for $60.00, the $100.00  bond for $60.00  the $100.00 face value was discounted 40 percent ($40.00) because we were buying the future value of $100.00  We have to wait for 20 years to get the full face value.

Difference from loan contract

A promissory note is very similar to a loan – each is a legally binding contract to unconditionally repay a specified amount within a defined time frame – but a promissory note is generally less detailed and rigid than a loan contract.  For one thing, loan agreements often require repayment in installments, while promissory notes typically do not. Furthermore, a loan agreement usually includes the terms for recourse in the case of default, such as establishing the right to foreclose, while a promissory note does not. Also, while a loan agreement requires signatures from both the borrower and the lender, a promissory note only requires the signature of the borrower.