As note investors, we need to know how to determine the rate of return for different Performing Notes. Remember, a “Performing Note” is a mortgage loan for which the borrower makes their payments on time, and the expectation is that this will continue through the life of the loan.

Assuming a note continues to “perform”, the rate of return for the note investor, which is called the “yield”, is determined by two factors:

1. The nominal, or stated, interest rate for the note.
2. The price paid for the note by the note investor.

Example

 

For example, let’s assume a brand new note is being originated with the following terms:

• Loan amount / UPB (Unpaid Balance): $100,000
• Annual Rate: 5%
• Term: 30  years (360 monthly payments)

Using a financial calculator, Excel spreadsheet, or financial calculator app, the originator of the loan will use the Time Value of Money calculation to determine the correct monthly payment:

• Monthly Payment: $536.82

Remember, the nominal rate of return of the loan is just %5. However, as note investors, we always buy notes at a discount.

For the ease of calculation, let’s assume that the newly originated note is immediately sold to a note investor.

Now, let’s assume the note investor wishes to buy the note, but also wants to earn a 7% return on his or her investment.

Using the same TVM calculation as before, but with a Annual Rate of 7.0%, the Present Value is calculated to be $80,688.11. This means that if the Note Investor reaches an agreement with the Note Originator to purchase the note for a price of $80,688.11, the Note investor will realize a 7% yield before fees and costs. The effective yield will be somewhat lower due to other costs such as closing costs and loan servicing fees, which we will discuss further in later posts.

Stated another way, for an investment of $80,688.11, the note investor will receive a total of 360 payments of $536.82 each month for 30 years, and end up yielding an annual 7%  return.

The major takeaway is this: the yield to the note investor is only partially based on the stated interest rate of the note itself. Ultimately, the price which is paid to the note seller by the note investor will determine the yield for the investor.

To summarize:

• Note investors always buy notes at a discount.
• The yield to the note buyer is determined by both the stated interest rate of the note and the price paid for the note.