What Actually Drives the Yield on a Note You Buy

The yield on a note you buy is set mostly by one thing: the price you pay for a given stream of payments. The note’s interest rate, its remaining term, whether you buy all of it or only part, and how much risk sits behind the payments all feed into that price. Nobody can promise you a particular return, but you can understand exactly which levers move it and which ones only look like they do.

This post walks through those levers with one worked example, so you can read any note offer and see where the yield is actually coming from.

First, two definitions

Yield is the annual return you earn on the money you put in, based on the payments you expect to collect and when you collect them. It is not the same as the note’s interest rate. The rate is what the borrower pays on the balance. The yield is what you earn on your purchase price.

Discount is the gap between the unpaid balance of the note and what you pay for it. Buy a $50,000 balance for $43,000 and the discount is $7,000. The discount is how a buyer earns a yield higher than the note rate. Our guide to what yield on a note means covers the definition in more depth.

The worked example

Say a seller holds a note with a $50,000 unpaid balance at 8% interest, with 20 years (240 monthly payments) left. The payment is about $418 a month. Here is what that same payment stream costs at different target yields. The numbers are illustrative and assume every payment arrives on time.

Two points stand out. Paying the full balance means you earn the note rate and nothing more. And every couple of points of extra yield costs the seller several thousand dollars, which is why sellers push back and why yield is always a negotiation over risk, not a number you simply choose.

Lever 1: the price you pay

This is the only lever you fully control. The payments are fixed by the note; your price decides what those payments are worth to you. Paying $40,000 instead of $43,340 for the note above lifts the yield from 10% to roughly 11.2%, if every payment arrives.

That “if” matters. A deeper discount is usually available because the note carries more risk: a thin down payment, a short payment history, a weak borrower, a property in poor condition. A bigger discount on a riskier note does not mean a better deal. Our guide on how to price a note as a buyer shows how to adjust price for each of those risks.

Lever 2: the note rate and the term

A note written at 9% is worth more than the same balance at 6%, because the borrower is paying you more. A shorter remaining term is usually worth more per dollar of balance too, because you get your money back sooner and there is less time for something to go wrong.

These features are set when the note is created. As a buyer you cannot change them, only price them. A low-rate, long-term note needs a bigger discount to reach the same yield as a higher-rate, shorter one.

Lever 3: buying all of the note or only part of it

A partial is a purchase of only some of the payments, usually the next few years of them, after which the remaining payments go back to the original holder. In the example above, a buyer could pay about $25,190 for the next 84 payments and target 10%, rather than paying $43,340 for all 240.

Partials let a buyer put less money into one note and get it back faster. The protection comes from the fact that the buyer’s money is covered by the whole property, while the buyer only has a claim to part of the payment stream. The trade-off is reinvestment: your money comes back in seven years and you have to find somewhere to put it again. Read more about buying partials as an investor.

Lever 4: risk, which works against you

Every yield figure in the table assumes perfect payment. Real yield is what you collect after late payments, a default, foreclosure costs, legal fees and the time it takes to recover. A note bought at a 12% target can end up earning far less, or losing money, if the borrower stops paying and the property is worth less than you thought.

The main things that protect the yield you planned:

• Equity in the property. Measured by ITV, investment-to-value: what you paid for the note divided by what the property is worth. A lower ITV gives you more cushion if you have to foreclose.
• Seasoning. The length of on-time payment history. A borrower who has paid for three years is a different risk from one who has paid for three months.
• Lien position. A first lien is paid before a second lien out of any sale proceeds.
• Clean paperwork. A properly signed, recorded and assigned note is easier to enforce.

Our page on the risks of note investing covers each of these and what they cost when they go wrong.

Lever 5: costs and early payoff

Servicing fees, closing costs, title work and a broker price opinion all come out of your return. On a small note, a few hundred dollars of fixed costs can take a visible bite out of yield.

Early payoff cuts both ways. If you bought at a discount and the borrower refinances in year two, you collect the full balance early and your yield goes up, because you earned the discount over a shorter period. If you paid close to full balance, an early payoff mostly just ends your income stream sooner. Buying a note for more than its balance is where early payoff can actually lose you money.

What does not drive yield

A few things get sold as yield boosters and are not:

• Courses and memberships. Education has value, but it is a cost, not a return on the note.
• Buying from a broker or packager at a “guaranteed” yield. No one can guarantee a borrower’s behavior. Check every representation in the package yourself.
• A high note rate on its own. A 12% note to a borrower with no equity and no payment history is not a 12% investment. It is a bet on that borrower.

If you want to see what yields buyers are actually asking for on different kinds of notes, our guide to what yield note buyers look for sets out typical ranges and why they vary.

Bottom line

The yield on a note comes from the price you pay for its payments, shaped by the rate, the term, how much of the note you buy and how much risk you are taking on. A bigger discount looks better on paper only until you account for the reason the discount exists. Price the risk first, then decide whether the yield that is left is worth it to you.