First we calculate the notes future value:
Future Value = Principle * ( 1 + Interest Rate ) Number of Years
So for example, if we had $1000 and we loaned it for 10 years at 8% interest, the future value would be:
1000 * (1.08)10 = $2158.92
The $1000 is worth $2158.92 in the long run. Inflation can eat away as much as 3% of that compounded each year. Thats one of the reasons why note investors buy notes at a discount. The note in our example has a future value of $2158 but what is that money worth now? In order to earn that same $2158 adjusted for inflation, we would have to earn an extra 3% a year on our money! We can't do that, but if we adjust the formula for the extra 3%:
2158 = Present Value * ( 1.08 + .03 ) 10 years
We end up with a present value of $760. So a note investor knows that the thousand dollars that was loaned at 8% interest is actually only worth $760 presently to someone who wants to earn that 8%! It is actually only earning 5% because of inflation!
You can also adjust the formula if you want to get higher return than the note was written for. For example, if you wanted to earn 10% interest on that same note, plug it into the formula:
2158 = Present Value * ( 1.10) 10 years
The note is worth $832 to someone who wants to increase his return to 10% instead of 8%.
Knowing this is vital to a note broker. If you have an investor that you are working with, ask her how much of a return she is looking to get and you will be able to ballpark how much she will be willing to pay for notes.
