While it is important to be aware of asking prices, offering prices and recorded prices, it is equally important to evaluate the worth of each transaction in terms of its total package value. With such information and calculations, the value of alternative deals can be compared and negotiating strategies mapped out in advance.
Suppose a small store is marketed for $160,000 and a buyer offers $150,000--a figure which is accepted by the seller. The actual deal might look like this: $30,000 down with a $120,000 mortgage financed at 16 percent over 30 years. In addition, the buyer has settlement expenses of $6,500 and repair costs of $18,000.
The total potential price for this property exceeds $635,000 and here's why: if held for its entire term the mortgage will cost $580,935 ($1,613.71 per month x 360 payments). The value of repairs (say $18,000), settlement ($6,500) and the initial down payment ($30,000) raise the total to $635,435.
Both buyers and sellers can use a basic set of figures such as those above to produce more attractive deals. For instance, suppose the purchaser agreed to offer the full $160,000 but only if the seller would take back a 10-year second trust for $30,000 at 18 percent interest. Such a proposal might be attractive to a seller becuase it would produce $130,000 in cash plus a high-interest note, indeed a note with a better rate of return than might be available with alternative investments.
This deal also has a particular appeal to the buyer as well. The $30,000 note, assuming that it is "self-amortizing," a phrase which means that all principal and interest payments are made during the term of the loan and so there is no "balloon" payment with which to be concerned, would cost $64,866.67 ($540.55 per month x 120 payments). The first trust, $90,000 at 16 percent interest would now cost $435,701 ($1,210.28 per month x 360 payments).
By carefully structuring the deal there are better terms for both parties. The seller gets more from the property with the $30,000 second trust than would have been possible without such financing and the buyer benefits too: principal and interest costs are cut from $581,000 to $500,567--an $81,000 reduction in interest expenses over the life of the loan.
Not everyone intends or wants to hold a property for 30 years and so many deals are structured with near-term goals in mind. Revising the store sale once again, it could be set up this way: The buyer finances $100,000 of a $150,000 sales price and the seller holds a 10-year, $50,000 second trust with monthly payments of $500 at 15 percent interest. In this case, the second trust will have a balloon payment of $19,000. However, since the seller has no intention of holding the property for 10 years, the matter of a balloon payment is not bothersome because the buyer, in reality, is only renting the use of that money until the property can be resold. Note, incidentally, that this arrangement requires no money down, thereby conserving cash for repairs and other costs.
But suppose that the rate of interest for the second trust was calculated at 9 percent annually. Since that interest rate was below the prevailing figure for a less risky first trust (15 percent in this illustration), it would mean the price paid for the store was actually discounted. The reason: had the seller gotten cash instead of a low-interest note he or she could have invested the money elsewhere and received a higher rate of return.
The examples above illustrate two points. First, the cost of money is the largest potential expense faced by almost all purchasers. Second, since the cost of money is based on both the rate of interest and the length of the loan, short-term mortgages are generally benefical to borrowers since inflation has the effect of devaluing cash over time, a situation which means that future debts can be paid in dollars that have less spending power. (Lenders, too, benefit from short repayment periods since risk on a given loan is reduced more quickly and such funds as they get back can be re-loaned, a process which involves new up-front fees and charges as well as possibly higher-interest rates.)
NEXT WEEK: financial art vs. financial science.