What is a Discounted Loan?
A discounted loan is a loan that is sold at a price less than its nominal face value. This can occur for several reasons, including differences in market interest rates compared to the loan’s interest rate, or due to the risk characteristics of the loan itself. The discount on the loan effectively compensates the purchaser for the lower interest rate or higher risk associated with the loan.
Examples of Discounted Loans
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The Deavers’ Case: When the Deavers sold their house, they accepted a second mortgage as part of the purchase price. They then sold this second mortgage to an investor for 75% of its face value. The investor who purchased this discounted loan is entitled to all the interest and principal payments stipulated in the mortgage contract.
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Corporate Bonds: A company may issue a bond at a discount if the prevailing interest rates are higher than the bond’s coupon rate. For example, a bond with a face value of $1,000 and a 5% interest rate may be sold for $950 if market interest rates are higher, providing the bond buyer a higher effective yield.
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Distressed Debt Investing: Investors may buy distressed loans, such as those in delinquency, at significant discounts. These loans are perceived as high-risk, but investors purchase them hoping to profit from their subsequent recovery or restructuring.
Frequently Asked Questions (FAQs)
Q1: Why would a lender sell a loan at a discount?
A: Lenders might sell loans at a discount to rapidly offload risky or non-performing assets from their balance sheets or to take advantage of current market conditions to immediate liquidity.
Q2: Is buying discounted loans risky?
A: Yes, buying discounted loans involves risk, as the discount often reflects underlying issues with the loan, such as borrower creditworthiness or unfavorable interest rate environments.
Q3: How does a discounted loan affect an investor’s return?
A: An investor’s return on a discounted loan includes both the interest payments and the appreciation of the loan towards its face value. The effective yield can be higher due to the initial discount.
- Discount: The reduction in the nominal value or price of a financial instrument.
- Discount Points: Fees paid directly to the lender at closing in exchange for a reduced interest rate.
- Mortgage: A loan used to purchase real estate, where the property serves as collateral.
- Par Value: The face value of a financial instrument.
Online Resources
References
- John, A., & Smith, X. (2020). Principles of Real Estate Finance. 5th ed. McGraw-Hill Education.
- Davis, R. E., (2018). Real Estate Investing: Market Analysis and Valuation Techniques. Wiley Finance.
Suggested Books for Further Studies
- The Book on Rental Property Investing by Brandon Turner.
- Investing in Debt: The Win/Win Strategy for the Little Guy by Jimmy Napier.
- Real Estate Finance & Investments by William B. Brueggeman and Jeffrey D. Fisher.
Real Estate Basics: Discounted Loan Fundamentals Quiz
### What defines a discounted loan?
- [ ] A loan bought for more than its face value.
- [x] A loan sold at a price less than its nominal face value.
- [ ] A loan that carries no interest.
- [ ] A non-recourse loan.
> **Explanation:** A discounted loan is defined as one that is sold at a price lower than its face value, usually due to factors such as interest rate discrepancies or the borrower's risk profile.
### What kind of yield might an investor expect when buying a discounted loan?
- [x] Higher effective yield
- [ ] Lower effective yield
- [ ] No yield at all
- [ ] Fixed nominal yield
> **Explanation:** An investor might expect a higher effective yield when buying a discounted loan because the investment cost is lower than the loan's face value, increasing overall returns through interest payments and face value recovery.
### What does the discount on a loan represent?
- [x] A compensation for the lower interest rate or loan risk
- [ ] A government subsidy
- [ ] A charitable contribution
- [ ] A nominal processing fee
> **Explanation:** The discount on a loan generally represents compensation for the investor, which could be due to a lower interest rate or increased risk associated with the loan.
### Why might a lender sell a loan at a discount?
- [x] To offload risky or non-performing loans quickly
- [ ] To make a charitable gesture
- [ ] To deliberately lose money
- [ ] To attract customers to their other products
> **Explanation:** A lender might sell a loan at a discount to rapidly remove risky or non-performing assets from their balance sheet or to leverage current market conditions for immediate liquidity.
### How does the purchase price of a discounted loan compare to its face value?
- [ ] Higher than face value
- [ ] Equal to face value
- [x] Lower than face value
- [ ] Variable based on market conditions
> **Explanation:** The purchase price of a discounted loan is lower than its face value, which compensates the buyer for taking on potential risks or accepting a lower interest rate.
### What are some examples of discounted loans?
- [ ] Standard fixed-rate mortgages
- [x] Corporate bonds sold below face value
- [ ] Credit cards with high-interest rates
- [x] Distressed debt investing
> **Explanation:** Examples of discounted loans include corporate bonds sold below face value and distressed debts, both commonly traded at a discount due to respective reasons such as market rates and borrower risk.
### What aspect can affect the degree of discount on a loan?
- [ ] The issuing country's Gross Domestic Product (GDP)
- [ ] The color of the loan documents
- [x] Market interest rates
- [x] The risk characteristics of the loan
> **Explanation:** Both market interest rates and the inherent risk characteristics of the loan can significantly affect the degree of discount applied.
### Are discounted loans always considered high-risk investments?
- [x] Often, but not always
- [ ] Never
- [ ] Rarely
- [ ] Always
> **Explanation:** Discounted loans are often considered high-risk investments because the discount typically indicates some level of increased risk, although this is not always the case.
### What happens to the interest and principal payments of a discounted loan once sold?
- [x] They go to the purchaser of the discounted loan
- [ ] They revert to the original lender
- [ ] They are forfeited
- [ ] They are split equally between the lender and purchaser
> **Explanation:** The interest and principal payments of a discounted loan are received by the purchaser, as part of the conditions of the loan sale.
### In what situation might an investor purchase a discounted loan?
- [x] Seeking higher returns through appreciation and interest
- [ ] Needing a quick loss for tax purposes
- [ ] Expecting zero payments
- [ ] Avoiding any form of investment risk
> **Explanation:** An investor might purchase a discounted loan seeking higher returns through both appreciation towards face value and received interest payments, accepting the associated increases in risk.
