Have you ever wondered how car manufacturers can make a profit by offering 0% financing to car buyers? It is a simple reverse calculation of the required note discount to determine how to set a Present Value (PV) for the note purchase. The car buyer can choose to pay a higher price for easy financing terms or to pay a lower cash price.
There are three parties to the transaction: (1) The seller, (2) the buyer, (3) the financier. The seller wants to receive a lump sum of $10,000 at the closing of the sale. The buyer wants 0% financing for, say, 60 months (5 years), fully amortizing. The financier wants to earn an annual yield of 10%.
Using your financial calculator, set the Future Value (FV) to zero (this is a fully amortizing note), set the term to 60 months, set the annual interest rate to 10%, set the Present Value (PV) to $10,000. Now calculate the monthly (periodic) payment. You have calculated the required payment stream to earn an annual yield of 10% on a $10,000 investment. (If the buyer is paying a down payment, then subtract that amount from the $10,000 to calculate the amount that is financed.)
Now set the annual interest rate to 0% and calculate the new PV (about $12,748 in this example). You have recast the note with front-loaded interest into an installment note with back-loaded interest and periodic principal-only payments.
The seller receives a note and security instrument from the buyer (no prepayment penalty). The note has the Unpaid Principal Balance (UPB) of $12,748 with 60 equal monthly principal-only payments. The buyer receives equitable title at the closing. The seller immediately sells the note and the security instrument (bare legal title) to the financier for $10,000 cash. The seller has his required cash, the buyer has purchased for 0% interest financing, and the financier has his 10% yield cash flow note. Everyone is happy. By the way, calculate the financier’s actual yield for an early pay off after 30 months. The early repayment increases the financier’s yield to 13.1%.
Sellers can attract more buyers by offering zero or negative interest rate financing by rolling the accrued interest into the price of their product.
A minor change to the above example is the car manufacturer offering negative two percent (–2%) financing. The lump sum to buy the note is the same as before; set Present Value (PV) to $10,000 and calculate the periodic payment for 60 months (5 years) for 10% yield. Then change the interest rate from 10% to –2%, and then recalculate the PV ($13,419.15) for the fully financed price with a negative interest rate.
The amortization schedule shows that the negative interest rate is increasing the principal reduction as a kind of “credit” that the lender is “contributing” to the borrower as an addition to the borrower’s effective monthly payment, essentially a kind of “rebate” or “reward” for making timely payments.
The total of the monthly payments from the borrower is the same as above $12,748 and the lender adds a “credit” of $671 for a total of $13,419 equaling the marked-up purchase price. The car manufacturer sold the note for $10,000 cash lump sum, the note buyer receives 60 payments of $212.47 for a total of $12,738.21 and an effective 10% yield on the $10,000 investment. The borrower made the same payments as in the zero percent scenario, and received a strong incentive to make all of the periodic payments, rather than an early pay-off, because of the monthly periodic “credits” or “rebate” built-in to the note.
If the note is redeemed early, then the borrower must make a larger redemption payment compared to simply making all of the monthly payments. The borrower “saves” money by not redeeming early the note. The reader should compute the amortization schedules to verify this result.
By altering the dollars and percentages, you can apply this simple principle to financing real estate transactions as either a buyer or seller or financier. I suggest that when you sell on terms, that you try to negotiate as large of a down payment as the buyer can afford (or structure the transaction with multiple notes and varying amortization terms), so that the financier that buys your note is secured by sufficient protective equity in the collateral.