Don’t Sell Notes At Large Discounts–Hypothecate

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By PETER ROSENTHAL, President
V.I.P. Trust Deed Company
(Reprinted from San Fernando Valley Apartment Management Magazine July, 1997)

In the February issue I devoted a column to discounted trust deeds.  I indicated in that column that a low interest rate (6-8%) and a long maturity (10-30 years) equals a huge discount.  The reasons are unimportant as they were covered in my previous article.  Let’s assume for the sake of this discussion that you sold a property and carried back a first trust deed of $200,000 at 7%, payable interest only, due in 10 years.   If you wish to sell that note today, the discount would range between 29% and 40%, depending on whether a retail or wholesale buyer.  I am therefore indicating that the discount would be anywhere from $58,000 to $80,000.

Let’s further assume for the sake of this discussions that the reason for selling the note is that you are trying to raise $40,000 to $100,000 for college tuition, family emergency of whatever.  In this example it would be horrendous to suffer a $58,000-$80,000 discount on a perfectly good note just to raise $40,000-$100,000.   Yes, a company like mine makes money buying and selling notes, but we much prefer to solve the “actual problem” rather than take advantage of the situation.

In this example, I would suggest that the beneficiary not sell the note and suffer the discount, but instead BORROW the required funds using the note and trust deed as collateral.  This process typically referred to as hypothecating the note, or simply borrowing money using the note and trust deed as collateral.  In the above example,   the interest rate on a $50,000 loan might be 11-12% and the broker’s points for a five year loan might be quoted in the 4-6 point range.  Maybe you think 4-6 points sounds expensive, but that works out to $2,000-$3,000 on a $50,000 loan, which is a very small fraction of a $56,000-$80,000 discount.  In most cases this is arranged so that the property owner’s payments are paid to the broker arranging the loan and the funds are used to repay the collateral obligation.
Sometimes the entire amount is used to satisfy the smaller loan on a fully amortized basis, and sometimes the smaller loan is an interest only loan with any difference in proceeds actually being returned monthly to the collateral borrower.

I am not trying to be “cute” in this example, and there are other factors to consider.  When figuring the total costs involved, certainly one must realize that they are earning 7% on the $50,000 portion of the loan and paying (in my example) 11-12%.   That is truly an additional cost of the loan.  There are also some severe Internal Revenue Service ramifications as the IRS considers hypothecation the equivalent of a sale and any taxes still due on the IRS (from the installment sale) are due upon hypothecation or sale of the note.

The purpose of this article was merely to alert beneficiaries that there are other options available when considering selling a note at a large discount.  Instead of ending on that note, let me add a few comments about large discounts.  If the trust deed is well secured, the interest rate is market and the term is not too long, the discount would be quite reasonable.  Often I quote discounts in the 5-8-12% range.   If the note is not a good note, for instance seller carry back second 80/10/10 (80% first, 10% down payment, 10% second). The loan to value ratio (LTV) is 90%–That just plain stinks.  This discount may be 40-50%.  Is that outrageous?  If I buy a $10,000 note for $5,000 (huge discount) and the first forecloses, I have now lost 100% of my money.  If I am going to take big chances on a risky trust deed I would rather go to Las Vegas and at least see bright light and free drinks.

Is your note safe, short-term, with a reasonable interest rate?  If so, the discount will not be severe.

Peter Rosenthal
VIP Trust Deed Company