One of the most misunderstood aspects of tax sales is what you actually earn from a tax lien that redeems. This confusion arises due to the fact that what you earn varies in two major ways, both of which have the term “percent” in their name.
Penalties versus Interest Rates: Some states pay an interest rate and other states pay a penalty. Let’s use the example of two states that both pay 12% on their tax liens, but one pays a 12% interest rate and the other pays a 12% penalty. Is there a difference? The answer is yes, and it could be a large difference.
Interest Rate Payment: If you are being a 12% interest rate you are being paid 1% per month for each month you hold the tax lien. If it is a $1,000 tax lien that means you earn $10.00 each month. If the lien redeems in three months you will make $30. If it redeems in six months you will make $60.
This is what most people think that tax liens do, and even the explanation above is not quite right, because you are entitled to a full months interest even if the lien redeems on the 1st day of the month. So if you held the lien for three months and one day, you would make $40 on your $1,000 lien. If the holding period ran from March 1st to June 1st, that would be a annualized return of $15.69% rather than 12%, because you earned another $10 for holding the lien for just one additional day past three months.
Penalty Payment: A penalty is stated as an interest rate, for example they might say the lien has a 12% penalty, but it is not an interest rate at all. A 12% penalty on a $1,000 lien is $120. If the lien pays a 12% penalty you will receive a $120 if the lien redeems on the last day of the first month after sale, or if it redeems on the last day of the sixth month after sale, or if it redeems on the last day of the twelfth month after sale.
That means, in interest rate terms, that your annualized interest rate you received if it redeemed on the last day of the first month after sale was 146%. If it redeems on the last day of the sixth month after sale it is a 24.06% annualized rate of return. It is only if it redeems on the last day of the twelfth month after sale that it is a 12% annualized rate of return.
Obviously, when comparing two states and what they pay, it is very important to note if one is paying a 12% interest rate and the other is paying a 12% penalty.