Structured settlements represent a stream of payments, often extending twenty years into the future. If you sell this stream, you cannot expect the buyer to pay you the total of these future payments. In fact, you will get much less, depending on the amounts and years involved. Let us look at how the buyer computes the amount to pay you.
Money Has A Time Value
If you have 10000 dollars in hand now, you could invest it in different ways. If you are a small businessperson, you could use it to improve your publicity efforts and expand your production capacity. These might result in the 10000 dollars doubling in a year’s time.
Or, if you are a stock investor, you could trade in stocks and probably make the 10000 dollars grow into at least 12000 dollars by the end of the year.
More modestly, you could invest in an interest-paying security and earn a 5% interest paid every quarter. That could make the 10000 dollars into 10510 by end of the year.
Another possibility is to invest the money in a training program that provides you with a vocational skill in high demand. You could thus enhance your earning potential and thus earn a return on that investment.
What all the above examples indicate is that money in hand now could earn returns and accumulate into a larger sum by a future date. This is called time value of money.
Future Payments Are Discounted
Considering the time value of money, sums received on future dates are discounted to compute their “present value”, i.e., value now. This is typically done using prevailing interest rate in the market. For example, we found that 10000 dollars invested at 5% interest, paid quarterly, become 10510 dollars at the end of one year.
Hence, the present value of 10510 dollars received one year from now is only 10000 dollars. Present value is always based on a rate of interest, and the “interest compounding” method used. Interest compounding means the frequency with which interest is computed and added to the principal. In our example above, the compounding was done every quarter. Next quarter’s interest would be computed on this interest-added principal amount.
The future payments you receive under a structured settlement are discounted in a similar fashion. Each of the payments would be discounted based on when it is received. Consequently, the amount you receive now, based the present values of all the different payments, would be much less than their total.
Use the Cash Well
It is possible that you are cashing out your structured settlement to meet unavoidable necessities, like paying off a debt or meeting medical expenses. In such a case, you have no option but to use the cash to meet these.
However, if the cash out is for other purposes, try to invest it in a way that earns you a good return. For example, you could invest it in a home, in a suburb where property prices are going up. Or take up a vocational course that would enhance your employability.
If you already have a decent income from other sources, you might even consider taking a vacation to recharge yourself.
Try to earn a return that would be higher than the interest you paid for cashing out. (The discounting of structured payments to present value is actually a kind of interest payment.)
Select A Buyer Carefully
The buyer of your structured payments should have certain qualifications.
Firstly, the person (or firm) must be experienced in the field. Cashing out structured settlements involves several legal formalities. Unless the buyer is experienced enough to handle all the formalities correctly, you might find yourself in trouble. If a legally binding assignment is not created, the original payer might refuse to pay your buyer.
Secondly, select a buyer who deals up front with you, explaining what to expect. Otherwise, you might come to have undue expectations and get into unnecessary conflict with the buyer.
Finally, select a firm that believes in ethical practices. Unethical firms might tell you one thing and do something else. They might also not give you a fair deal.