Discount Explained To maximize the value of a financial instrument, such as a promissory note, its purpose and goals must be well thought out; it must be well structured and well drafted.
Ideally, it should be valued at its face amount, or its unpaid balance.
The overall goal is to avoid flaws that will cause an appraiser or a purchaser to reduce its price or value--to discount it value.
This reduction in value factor is called "the discount" and the investor's goal is to minimize it.
Financially speaking, discounts are painful.
Fundamental Causes of Discounts Ignorance, lack of planning, and changes in financial market conditions are three of the fundamental reasons that cause flaws and mistakes that trigger the discounting of the note.
These discount causing factors apply to all aspects of the promissory note creation process-conceptualizing the transaction, structuring it, and document it.
Let's examine how they apply to the creation and drafting of the note itself and its accompanying file.
Essential Concepts for Promissory Note Appraisal and Valuation An dangerous misunderstanding exists among some investors, attorneys, and CPAs; they feel that drafting a note is a "no brainer" -a "slam-dunk".
If you look on the web you will find numerous offers of "free" promissory note forms that can use to "do it yourself".
The implication is that just about anyone who can type can fill in the blanks on a note form properly, and that the finished note will be as "good as gold".
Truth be known, this is a gross misunderstanding of just how many moving parts exist that must be synchronized to maximize the fair market value of the promissory note.
The intricacies and the pitfalls involved in creating a promissory note are many and varied.
Let's explore and examine some of the most important ones.
Legalities Is the transaction that creates the promissory note legal? As examples, the following financial transactions may note be enforceable in a court of law: borrower or the lender is a minor, borrower or lender is mentally incompetent, borrower or lender is acting under duress, borrower or lender have a mistaken understanding of the terms of the transaction, the legal description of the property is inaccurate.
An unenforceable note will be very heavily discounted.
Borrower's Financial Condition Many notes are created without determining and documenting the financial condition of the borrower.
Additionally, many are created that do not have documentation that shows the borrowers Social Security number, employment status and payment histories, credit score, character references, etc.
Having the financial facts and the supporting documents that go with them is critical; lack of them causes a major valuation discount.
Collateral Security All promissory notes contain the promise of the borrower to repay the debt.
These notes are called "unsecured" because they lack additional collateral security.
Should the borrower be unable to make the payments, the note holder will suffer a loss.
If the note has a recorded lien on an asset (real estate mortgage) or the pledge of an asset represented by a UCC-1 Statement, in addition to the borrower's signature, it is called a "secured note".
The collateral security must be legally identified and legally encumbered so that it is tied to the note as a guaranty of repayment.
Many notes that are considered to be "secured notes" are in fact poorly secured, or actually unsecured, because of drafting flaws and recording deficiencies.
Probably the most prevalent error is not having documentation that proves that a mortgage lien exists, and, if it exists, its rank or its priority.
Many loan packages contain a copy of a Mortgage or Deed of Trust, but no evidence that they were recorded; and, if recorded, at what order or priority are they ranked; were they recorded in first position, second position, or third position.
Lack of collateral security and/or its rank or priority causes many, many discounting situations.
Summary In this article we have examined some of the flaws and errors that cause discounts to be applied to the fair market value of a promissory note.
We focused on the borrower's information, the drafting of the note itself, and on obtaining and documenting the collateral security.
In the next article we will continue learning how to avoid having a note discounted by examining some additional flaws and errors within the note file that are responsible for discounts.
Remember: • We can also learn from our mistakes.
But the cost of learning is not cheap.
• You must learn from the mistakes of others.
You can't possibly live long enough to make them all yourself.
• Experience is the name we give to our mistakes.