Gross and net yield worked on one illustrative performing note, then the same fees applied to notes from 15,000 to 160,000.
A fixed monthly servicing fee comes off every payment the note makes, so its cost in yield depends on the size of the note, not on its rate. On an illustrative 40,000 performing note at 9 per cent bought at 85 per cent of balance, a 30 a month servicing fee plus 600 of boarding and acquisition costs cut the yield from 11.38 to 9.82 per cent, 156 basis points. The same fee costs 420 basis points on a 15,000 note and 39 on a 160,000 one.
Worked in full in The Mortgage Note Investor by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A performing first lien with twenty years left to run, offered at 85 per cent of its unpaid balance. The seller quotes the yield on the price, which is the gross yield. The buyer pays a licensed servicer to collect the payments, keep the escrow and send the statements, and pays once to board the loan and once more for the checks before the wire: a title search, a broker price opinion and a review of the collateral file. All figures are illustrative, in dollars; yields are annual rates compounded monthly.
| Input | Value |
|---|---|
| Unpaid balance | 40,000 |
| Note rate | 9% |
| Remaining payments, months | 240 |
| Price, % of balance | 85% |
| Servicing fee, a month (performing) | 30 |
| Boarding fee, once | 150 |
| Acquisition costs (title, BPO, collateral file) | 450 |
Step 1: the payment. 40,000 at 9 per cent over 240 months amortises at 359.89 a month.
Step 2: the gross yield. Solve for the rate that discounts 240 payments of 359.89 to the 34,000 price.
34,000 = Σ 359.89 / (1 + y/12)t, t = 1 to 240 ⇒ y = 11.38%
Excel: =RATE(240, 359.89, -34000)*12
Step 3: the net yield. Take the servicing out of each payment and add the up-front costs to the price.
34,600 = Σ (359.89 − 30) / (1 + y/12)t ⇒ y = 9.82%
Excel: =RATE(240, 359.89-30, -(34000+150+450))*12
The 30 is 8.3 per cent of every payment. Over the life of the note the buyer pays 7,200 of servicing, 7,800 with the up-front costs, on a 34,000 purchase. Split the 156 basis points and the monthly fee accounts for 131 and the up-front costs for 27; the two do not add exactly because they interact.
Same rate, same term, same 85 per cent price, same fees. Only the balance changes.
| Unpaid balance | Payment | Servicing, % of payment | Gross yield | Net yield | Drag, bp |
|---|---|---|---|---|---|
| 15,000 | 134.96 | 22.2% | 11.38% | 7.18% | 420 |
| 25,000 | 224.93 | 13.3% | 11.38% | 8.88% | 250 |
| 40,000 | 359.89 | 8.3% | 11.38% | 9.82% | 156 |
| 80,000 | 719.78 | 4.2% | 11.38% | 10.61% | 78 |
| 160,000 | 1,439.56 | 2.1% | 11.38% | 11.00% | 39 |
The gross yield is identical on every line, which is why a listing that quotes it tells you nothing about the small note. The drag roughly halves each time the balance doubles. On these terms a note needs a balance of about 62,325 before fees cost less than 100 basis points. Below that, the servicer is a large partner in the deal: on the 15,000 note it takes more than a fifth of every payment.
A payoff at month 60 shortens the period over which the up-front costs are spread, but it also brings the discount home sooner. On the 40,000 note the balance outstanding then is 35,483, the gross yield rises to 13.32 per cent and the net to 11.82, a drag of 150 basis points, about the same. On the 15,000 note the net yield is 9.38 against 13.32 gross, 394 basis points lost. The worse case is default: non-performing servicing at an illustrative 95 a month is 1,140 a year, 3.4 per cent of the 34,000 price, paid while nothing comes in. That is why a non-performing bid has to carry servicing month by month until the court is done.
Partials make it worse. Buy only the first 60 payments of the same 40,000 note at the same 11.38 per cent gross yield and the price is 16,407. The servicer still charges 30 a month on the whole loan and the boarding and checks still cost 600, so the net yield falls to 6.14 per cent, a drag of 525 basis points. Who pays the servicer in a partial, the seller or the buyer, is a term to negotiate before the price, as the arithmetic in how to price a partial note shows.
The common mistake is to pay the price that earns the target yield gross and to treat servicing as an overhead. If the buyer's hurdle on this note is 11.38 per cent, the price that earns it net of the fee and the costs is 30,566, or 76.4 per cent of the balance, not 34,000. Paying the ask gives away 3,434 on a single small note. Build the fee into the cash flow before solving for price, as in how to price a performing note for a target yield, and test the payoff months as in how an early payoff changes the yield.
The fixed costs on a small note and the minimum ticket that follows from them are worked in the free workbooks for The Mortgage Note Investor.
Servicers typically charge a flat monthly fee per loan, higher for non-performing loans, plus one-off boarding fees. Illustratively, 30 a month for a performing loan, 95 for a non-performing one and 150 to board. Because the fee is flat, its cost in yield depends on the balance: 156 basis points on a 40,000 note bought at 85 per cent, 39 on a 160,000 note.
Set it from the fee schedule and the yield you can afford to give up. With 30 a month of servicing and 600 of up-front costs on a 9 per cent, twenty-year note bought at 85 per cent, the drag falls below 100 basis points only above a balance of about 62,325. A 15,000 note on the same terms loses 420 basis points.
Net. Gross yield is the rate on the payments against the price; net yield takes servicing out of each payment and adds acquisition costs to the price. On a 40,000 note the 85 per cent ask earns 11.38 per cent gross but 9.82 net. To earn 11.38 net the price would have to be 30,566, or 76.4 per cent of balance.
This article is one calculation from The Mortgage Note Investor. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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