Note investors are paid by the interest in each payment the borrower makes and by the discount, which is the gap between the balance owed and the lower price the investor paid. Both depend on the borrower continuing to pay.
Interest
Every payment on an amortizing note has an interest part and a principal part. The interest is the charge on the balance still owed, and the principal pays that balance down. Whoever owns the note receives both: the interest as income, and the principal as the return of money that was lent.
If you bought a note for exactly its balance, interest at the note’s rate would be your whole return.
The discount
A buyer who wants a return above the rate written on the note has to pay less than the balance. The seller accepts less in exchange for cash now, and the buyer takes on the wait and the risk. The borrower still owes the full balance and keeps paying on it, so the same payments are a higher rate of return on the buyer’s smaller outlay than the note’s own rate.
That higher rate is the buyer’s yield on the note, and it is earned only if the payments arrive as scheduled.
How the two fit together
Take an example with invented round figures. A borrower owes $90,000 and a buyer pays $81,000 for the note. The discount is $9,000, which is 10% of the balance. The borrower’s payments are still calculated on $90,000 at the note’s rate, and every one of them now goes to someone who put in $81,000. The buyer collects the interest as it is paid and collects the $9,000 gradually, inside the principal part of each payment.
An example to show where the money comes from. It assumes the borrower pays on time, and it ignores servicing fees, due diligence costs, taxes and any loss from a default. It says nothing about what a real note would sell for or return.
Everything in that sum follows from the difference between unpaid balance and purchase price. Buyers who join the buyer list see the terms, the balance and the documents the seller has, which is what you need to run it on a real note.
If the borrower pays off early
Borrowers sell and refinance. When they do, they pay the full remaining balance, whatever the buyer paid for the note. In the example above, a payoff arriving while $88,000 is still owed would hand the buyer $88,000 on an $81,000 outlay, on top of the payments already collected. The discount arrives sooner than planned, which raises the yield on that note. The cost is that the payments stop and the money has to be put to work again.
Other ways buyers are paid
- Partials. An investor can buy a partial: a set number of payments, with the rest of the note returning to the seller. The return comes from interest and discount again, over a shorter period.
- Non-performing notes. The borrower has stopped paying, so the price is lower. The buyer’s return, if there is one, comes from getting the loan paying again, a negotiated payoff, or recovery through the property. Nothing is earned until the note is resolved, and costs come first.
- Reselling. A note can be sold to another buyer. Whether that produces a gain depends on what the next buyer will pay.
What comes off the top
The yield worked out at purchase is a gross figure. Before purchase you pay for title work, a valuation and legal review. While you hold the note a servicer, if you use one, charges a monthly fee. A default brings legal fees, taxes and insurance that you advance, along with months of no income. Then there is income tax. How income from notes is taxed depends on your situation and is a question for a CPA.
What all of it rests on
Every figure on this page assumes the borrower pays. If the payments stop, the yield you calculated stops with them, and what you recover depends on the equity in the property, your lien position and the cost of enforcing the loan. A price that looks generous at purchase can still lose money, which is why the checking you do before funding, the subject of much of the investor guide, counts for more than the yield you are quoted.
We make no claims about what you will earn. On any note you are offered, work out the interest and the discount as above, then ask what would be left of both if the payments stopped.
Related questions
Is the yield on a note the same as its interest rate?
Only if you pay exactly the balance. When you buy below the balance, the same payments are a higher return on your smaller outlay, so the yield is above the note rate. The yield also assumes payments arrive as scheduled.
Do note investors profit when a borrower defaults?
A default is a cost and a delay first. Recovery depends on the equity in the property, the lien position and the legal expense of enforcing the loan. Some defaults are resolved well and some end in a loss.