When the borrower stops paying the mortgage, he usually stops paying the taxes and the insurance too. In a foreclosure, the note holder pays them and rarely gets them back.
On a non-performing note that ends in foreclosure, every dollar you advance for property taxes and insurance comes out of your own return, because the sale proceeds are capped by the property's value, not by the debt. On an illustrative $120,000 first lien bought for $75,000, two years of advances total $20,100 and cut the yield from 26.1% to 15.6%. To keep a 20% target, the bid must fall from $85,121 to $67,204.
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 →
Most first-time bidders model the purchase price, the legal costs and the exit, and treat taxes and insurance as the borrower's problem. On a performing loan they are, through escrow. On a nonpaying one the borrower has usually stopped paying them too, and the note holder has to: an unpaid tax bill can lead to a tax lien or tax sale that ranks ahead of the mortgage, and an uninsured house is uninsured collateral. The servicer advances the money and charges it to the loan. Whether you ever see it again depends on how the loan ends.
| Input | Value |
|---|---|
| Unpaid principal balance, first lien | $120,000 at 7% |
| Property value (BPO) | $150,000 |
| Purchase price | $75,000 (50% ITV, 62.5% of UPB) |
| Delinquent taxes with penalties, paid in month 1 | $8,100 |
| Current property taxes | $3,600 a year, $1,800 every six months |
| Force-placed insurance | $2,400 a year, paid in advance |
| Servicing fee | $30 a month |
| Foreclosure legal costs | $5,000 in month 3, $3,000 in month 15 |
| Foreclosure sale / REO sale | Month 20 / month 24 |
| Selling costs on the REO | 8% |
Taxes: $8,100 of arrears plus four half-yearly bills of $1,800 = $15,300.
Insurance: two annual force-placed premiums of $2,400 = $4,800, twice what an owner's policy at $1,200 would cost.
Total advances to month 24: $20,100, or 26.8% of the purchase price and 13.4% of the property value. The tax arrears alone are 40% of it, and they are paid in the first month, when they cost the most in time value.
The advances are added to the debt. They are recovered only if something pays the debt in full.
Total debt at month 24: $120,000 principal + $16,800 of accrued interest + $20,100 of advances = $156,900.
Net REO proceeds: $150,000 × (1 − 8%) = $138,000.
Before any advance, principal and interest come to $136,800, only $1,200 below net proceeds. The advances push the debt $18,900 above what the property returns, and anything charged to the loan above $138,000 is a claim on nothing. If a third party buys at the foreclosure sale, at most $1,200 of the advances comes back; if you take the property as REO, you keep the proceeds whatever the debt says. Either way, in the foreclosure path the advances are, to within $1,200, pure cost, dollar for dollar.
This is what separates a first lien bought at a deep discount from one bought near par. When the debt sits well below the value, advances come back in the sale. When it sits close to or above the value, which is normal for a nonpaying loan with two years of arrears, they do not.
| Foreclosure path, sale in month 24 | Without advances | With advances |
|---|---|---|
| Purchase price | 75,000 | 75,000 |
| Legal and servicing ($720 of servicing) | 8,720 | 8,720 |
| Tax and insurance advances | 0 | 20,100 |
| Total cash in | 83,720 | 103,820 |
| Net REO proceeds | 138,000 | 138,000 |
| Profit | 54,280 | 34,180 |
| Multiple on cash | 1.65x | 1.33x |
| Yield | 26.1% | 15.6% |
The advances cost 10.5 points of yield. They do more damage than their size suggests because the largest piece, the tax arrears, goes out in month 1 and the money comes back, if at all, in month 24. In Excel, with monthly flows in a column: =IRR(B2:B26)*12, and the bid that hits a target with Goal Seek on the price cell.
Solving for the price that delivers 20%: $85,121 if you ignore the advances, $67,204 if you include them. A difference of $17,917, which moves the bid from 56.7% to 44.8% of the property value. A bidder who leaves advances out of the model will consistently pay about 12 points of ITV too much on loans like this one, and will win the auctions he should lose.
| REO sale month | Advances | Yield without | Yield with | Cost (points) | Bid for 20%, without | Bid for 20%, with |
|---|---|---|---|---|---|---|
| 18 | 18,300 | 35.2% | 22.3% | 12.9 | 94,884 | 78,178 |
| 24 | 20,100 | 26.1% | 15.6% | 10.5 | 85,121 | 67,204 |
| 30 | 24,300 | 20.6% | 10.8% | 9.8 | 76,244 | 55,643 |
| 36 | 26,100 | 17.0% | 8.3% | 8.7 | 68,205 | 46,611 |
The points of yield lost fall as the timeline lengthens, but only because every yield is lower. The dollar gap in the bid widens, from $16,707 at 18 months to $21,594 at 36. A slow state makes the advances a bigger share of everything that goes wrong. The court timeline itself is priced in what a judicial foreclosure takes off the bid.
If the borrower reinstates or pays off, the advances are part of what is owed: the reinstatement figure includes the corporate and escrow advances, as worked in how to calculate a mortgage reinstatement amount. If the loan is modified, they are usually capitalised into the new balance, which only helps if the borrower keeps paying. So the advances do not change the value of the good outcomes much. They change the value of the bad one, which is the outcome the bid has to survive.
The usual error is checking the title report for a tax lien, seeing none, and assuming there are no tax arrears. Arrears that have not yet gone to a lien sale do not show up as a recorded lien. Ask the seller for the tax status and the insurance status of each loan, or pull the county tax record yourself, before you bid. The second error is pricing insurance at the owner's premium: once the policy lapses, the servicer places cover at its own rate, $1,200 a year more here, and it keeps doing so until the property is sold.
Before you bid: estimate advances to the end of the realistic timeline, test whether total debt exceeds net REO proceeds, and if it does, deduct the advances from the bid in full.
On a nonpaying first lien where the debt already exceeds the value, taxes and insurance are part of the purchase price paid in instalments. The book's nonpaying first lien, bid month by month from its foreclosure floor, is in the free workbook for this case.
They are added to the debt, so they are recoverable whenever the debt is paid in full: on a reinstatement, a payoff or a sale that covers everything owed. In foreclosure they are recovered only if net sale proceeds exceed the debt. In the illustrative case the debt is $156,900 against $138,000 of net proceeds, so all but $1,200 of the $20,100 of advances is unrecoverable.
Because unpaid property taxes can lead to a tax lien or tax sale that ranks ahead of the mortgage, which could wipe out the investor's security. Paying them protects the collateral. In the illustrative case the arrears with penalties are $8,100, paid in the first month, and they make up 40% of all advances over two years.
It varies by servicer and property, but it is usually much dearer than the owner's own cover. In the illustrative case the force-placed premium is $2,400 a year against $1,200 for an owner's policy, an extra $1,200 a year that the note holder carries for as long as the property is unsold.
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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