A worked owner-financed note with a balloon: the price at a required net yield, the yield at the seller's ask, and what payoff and extension do to it.
The price of a performing mortgage note is the present value of what you will actually receive, each payment net of servicing plus the balloon, discounted at your required yield, less the up-front costs of buying it. On the fictional Mesquite Lane note, 58 payments of 1,112.56 and a balloon of 132,969.45, discounted at 11 per cent and less 1,400 of costs, give a price of $126,802.91, or 90.71 per cent of the unpaid balance. The seller asks 92 per cent, which earns 10.63 per cent net.
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 →
Mesquite Lane is the performing note in The Mortgage Note Investor: an owner-financed first lien with a balloon, offered at 92 per cent of its balance. All figures are illustrative. Yields are annual rates compounded monthly.
| Input | Value |
|---|---|
| Original balance | 142,000 |
| Note rate | 9.00% |
| Amortisation | 360 months |
| Balloon due at payment | 84 |
| Payments already made | 26 |
| Value of the house (BPO) | 176,000 |
| Acquisition costs plus servicer boarding | 1,250 + 150 |
| Servicing fee | 30 a month |
| Required net yield | 11% |
Step 1: rebuild the note. The monthly payment on 142,000 at 9 per cent over 360 months is 1,142.56. After 26 payments the unpaid balance is 139,782.42, a loan-to-value of 79.42 per cent. The balloon falls due after payment 84, so the buyer receives 58 more payments and then the balance outstanding at that date, 132,969.45.
Step 2: net the cash flows. The servicer keeps 30 a month, so each payment is worth 1,112.56 to the buyer. Acquisition and boarding cost 1,400 on day one.
Step 3: discount at the required yield.
Price = Σ (P&I − servicing) / (1 + y/12)t + balloon / (1 + y/12)58 − costs
= 49,877.29 + 78,325.62 − 1,400 = 126,802.91
As a share of UPB: 126,802.91 / 139,782.42 = 90.71%; investment-to-value 72.05%
Excel: =PV(11%/12,58,-(1142.56-30),-132969.45)-1400
The balloon is 61.1 per cent of the value bought. That matters: the yield depends more on whether the borrower can refinance 132,969.45 in month 58 than on the monthly payments.
The ask is 92 per cent of UPB, 128,599.83, which is 1,796.92 above the price at 11 per cent. Solve for the yield at the ask and it is 11.19 per cent gross, before costs and servicing, but 10.63 per cent net. The gross figure is the one the seller quotes.
| Required net yield | Price | % of UPB |
|---|---|---|
| 9% | 136,975.69 | 97.99% |
| 10% | 131,775.08 | 94.27% |
| 11% | 126,802.91 | 90.71% |
| 12% | 122,048.58 | 87.31% |
| 13% | 117,501.99 | 84.06% |
At 9 per cent, the note rate, the price is still below par, 97.99 per cent, because the costs and servicing come out of the buyer's pocket. Each point of required yield is worth between 3.25 and 3.72 points of price on this note, less as the yield rises.
The price assumes the borrower pays to the balloon. The timing changes the yield earned at that price, in both directions:
| Outcome | Net yield |
|---|---|
| Paid off at month 12 | 17.88% |
| Paid off at month 24 | 13.53% |
| Paid off at month 36 | 12.09% |
| Balloon paid at month 58 | 11.00% |
| Balloon extended 60 months | 10.13% |
| No balloon, full amortisation | 9.71% |
A note bought at a discount rewards speed: the 12,979.51 of discount is collected sooner. An extension does the opposite, and an extension is exactly what a borrower who cannot refinance will ask for.
The common mistake is to discount the note's own payments at the target yield and stop there. Priced gross at 11 per cent, without servicing or acquisition costs, Mesquite Lane is worth 129,547.84. A buyer who pays that earns 10.44 per cent net and has overpaid by 2,744.93. Costs and servicing together are worth 2.0 points of price on a note this size; on a small note they can be worth several.
The second mistake is to ignore the balloon and price on the 334 months of full amortisation. At 11 per cent that gives 114,209.52, 81.71 per cent of UPB, and the buyer loses the deal to someone who read the note. Price on the contract as written, then test the extension and the payoff months as sensitivities, as above.
A performing note can still default, and a non-performing one is priced from a different floor: the foreclosure path, worked in how much a judicial foreclosure takes off the bid.
The yield-to-price table, the payoff months, the partial and the default overlay are live formulas in the free workbook for this case.
There is no fixed answer: it depends on the borrower, the equity in the house, the balloon and the size of the note. The worked case uses an illustrative 11 per cent net target on a 9 per cent note with 79.42 per cent loan-to-value. At that yield the price is 90.71 per cent of UPB; at 9 per cent, the note rate, the price is still only 97.99 per cent because of costs and servicing.
The balloon is usually most of the value. On Mesquite Lane the 132,969.45 balloon due in 58 months is 61.1 per cent of the present value bought at 11 per cent. If it is extended 60 months, the yield at the same price falls to 10.13 per cent; if the note had no balloon at all, it would be 9.71 per cent.
Gross yield discounts the borrower's payments against the price alone; net yield also deducts servicing fees and the costs of buying. At the seller's 92 per cent ask, Mesquite Lane yields 11.19 per cent gross and 10.63 per cent net. Pricing gross at 11 per cent would mean paying 129,547.84 and earning 10.44 per cent net.
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.
Get the book on Amazon →Free companion files
Also on Amazon UK · Amazon Germany · Amazon France · Amazon Canada
Reading guide: real estate investing, finance and fund management → · All 453 articles →
If this book helped, or didn’t, a few lines on Amazon are worth more than they look: they are what the next reader goes on. Write a review. The workbook stays free either way.