You price a note by choosing the yield you need for its risk, then discounting each remaining payment back to today at that yield. The total is the most you can pay. The rest of pricing is choosing the right yield and checking the answer against the property.
A seller thinks about the discount and a buyer thinks about the yield. They are two views of one number, and the buyer’s view is the one that sets the price.
Price follows yield
Yield is the annual return on your money, assuming the payments arrive when they are due. A payment due far in the future is worth less to you today than one due next month, because your money is tied up longer waiting for it. Discounting is the arithmetic that puts a today-value on each future payment.
The inputs are short enough to fit on an index card:
- The payment amount.
- The number of payments left, and their dates.
- Any balloon, which is a large final payment.
- The yield you require.
The first three are facts from the note, and the fourth is your judgment. A financial calculator or a spreadsheet’s present value function does the rest.
What the arithmetic does to the price
Discount a note’s remaining payments at the note’s own interest rate and you get the balance owed. That is what a balance is: the value of the remaining payments at the note rate. Discount the same payments at any yield above the note rate and the answer falls below the balance. The gap between the two is the discount.
It follows that the size of the discount depends on how far the note’s rate sits below the yield buyers want. A note written at a rate close to that yield sells near its balance, and a note written at a low rate sells well under it, however good the payer is. Term works the same way: the more years of payments there are to discount, the more a given gap in rates takes off the price.
We keep the worked figures in one place so they agree across the site. How note buyers calculate a price runs a full example with the balance, the yield and the resulting discount, written for the seller who will be reading your bid.
Choosing the yield
Your required yield starts from what you could earn elsewhere for less trouble, then rises with each risk the note carries. Nobody can hand you the right number, but the factors that move it are well known, and they are the ones the investor guide uses to judge a note’s quality.
| Factor | Supports a lower yield and a higher price | Calls for a higher yield and a lower price |
|---|---|---|
| Payment record | Years of on-time payments, independently documented | A new note, late payments, or no proof |
| Equity | A large down payment and a balance well below the value | Little down, or a value that has fallen |
| Lien position | First lien | Second lien |
| Property | Owner-occupied house in an active market | Vacant land, specialized or rural property |
| Payer | Stable income and a sound credit record | Weak credit or uncertain income |
| Paperwork | Complete, recorded, professionally drafted | Gaps, errors or home-made documents |
| Term | Fewer years to wait | A long term or a distant balloon |
| Location | A state where enforcement is quicker and cheaper | A state where it is slower and costlier |
Write your yield rules down before you look at deals. A buyer who settles the yield after seeing the note is under pressure to find a reason to pay what the seller wants.
The second test: investment to value
A yield tells you what you earn if things go right and nothing about what you hold if they go wrong. For that you need the property.
Investment to value, or ITV, is your purchase price divided by the property’s current value. Loan to value, or LTV, is the balance owed divided by the same value. As an example, take a property worth $100,000 with $75,000 owed on the note. The LTV is 75%. If you buy the note for $60,000, your ITV is 60%. LTV describes the payer’s position and ITV describes yours, because if the payer stops and you end up relying on the property, your price is what you need to recover, along with the costs of getting there.
A sound habit is to set a ceiling on ITV for each kind of property and refuse to go above it whatever the yield. A note then has two prices, the one your yield produces and the one your ITV ceiling allows, and you pay the lower.
Costs that come out of your yield
The yield on your calculator is a gross figure. Your real return is lower by everything you spend to buy and hold the note.
- Title work, recording and legal fees at purchase.
- The valuation and any inspection.
- The monthly servicing fee for the life of the note.
- Any fee to the party that brought you the deal.
- Time your money sits idle before the purchase and after an early payoff.
Add purchase costs to the price and take servicing off the payment before you solve for yield. A flat monthly fee weighs more on a small note. To pick figures purely for illustration, a $25 fee is 5% of a $500 payment and 2.5% of a $1,000 payment.
Pricing a partial
The same method prices part of a note, where you buy a set number of payments and the note then returns to the seller. You discount only the payments you are buying, so the price is smaller and so is the total you will collect.
At a given yield, what changes most is your ITV. It falls sharply on a short partial, because your price is small against the same property, and a buyer may decide that the extra cushion justifies a lower yield than they would ask on the whole note. The price is the easy half of buying partials as an investor, and the agreement on early payoff and default is where two bids at one yield can differ.
When the payer is not paying
Yield pricing needs payments to discount. On a defaulted note there are none you can count on, so buyers price from the property instead: its value, minus what stands ahead of the lien, minus the cost and time of resolving the default, with a margin for being wrong. The unpaid principal balance, or UPB, is the most you could collect and has little to do with what the note is worth, which is why UPB and purchase price sit so far apart on a defaulted note.
Keeping your own pricing honest
Work out your number before you hear the asking price. Once you know what the seller wants, it is hard to price as if you did not.
Run the bad case as well as the scheduled one. Recalculate with six months of missed payments followed by a workout, and see what your yield becomes.
Then show your working. A bid that comes with the yield and the reasons behind it is easier for a seller to accept, and harder for you to talk yourself out of. On notes that come through us it is expected, since the seller is shown how each offer was priced.
A note to price tonight
Take any summary sheet, write your yield rule at the top, and produce both prices: the one from the yield and the one from your ITV ceiling. For sheets to practice on, join the buyer list with the yield and ITV limits you work to. If the two prices land far apart, find out which input is driving the gap: a low note rate drags down the price your yield produces, and thin equity means your ITV ceiling allows far less than the balance.
Related questions
Is the yield the same as the interest rate on the note?
No. The interest rate is what the payer is charged on the balance. The yield is what you earn on the price you paid. They only match if you pay exactly the balance. Pay less than the balance and your yield is higher than the note rate.
What tool do I need to price a note?
A financial calculator or a spreadsheet. You enter the payment, the number of payments and your required yield, and solve for present value. If the note has a balloon, you add it as a final lump sum.
Should I pay more for a note with a higher interest rate?
All else equal, yes. A higher rate means larger payments on the same balance, so the same yield produces a higher price. Check that the payer can afford that rate, though, because a payment that strains the household raises the chance of default.