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Unearned Discount

If a note seller came to you looking for an offer on their performing note, how would you price it? Would you base it solely upon yield? Perhaps consider investment value ratio? The borrowers credit worthiness?

Well, if you have been following this blog, you know the answer is a combination of variables, which include all of the above-mentioned items and more. What if it were more complicated?

For example, how would you price it if it were a $100,000 unpaid balance sub-performing 400-month note written at 2% backed by a $150,000 owner occupied house that’s in Bankruptcy chapter 13 with a $20,000 arrearage? Price it too high and you are overpaying, price it too low and you offer will be rejected.

If that were all of the facts that you know at this point, what calculations would you perform to come up with an initial offer?

I am going to use some common ratios that we see some investors use:

If you use a 70% ITV, you priced it too high as your offer would be $105,000. If you offer it using a 14% yield, you are coming in too low at $29,092. If you use 70% of UPB, your yield is about 4.6%.

Investors who simply use the above ratios would pass on this deal.

We had a similar deal the other night that Eddie Speed was guiding someone through. Eddie, almost immediately said that this would be a good buy at around $48,000. That would end up being about an 8% annualized yield.

Now for most investors an 8% yield is great, but sometimes note investor’s price assets on yields from 12-16% and if they can’t get that yield they pass. It is a mistake to focus simply on yield as one will pass on deals that make a lot of financial sense and opportunity.

These investors don’t understand the concept of “unearned discount”. Eddie illustrated this concept by using a chart that shows the unpaid balance over time as compared to the note investor’s investment


The top of the yellow line shows shows the loan payoff over time, while the top of the green line shows the investors’ investment amount over time. The difference between the two lines is the investors “unearned discount.

If, for example, the note was paid off in the 65th month, the total payoff would be about $88,000 while the investor has about $46,000 in the deal at that point. The difference, $42,000, is the “unearned discount”. Obviously , the investors yield would take care of itself at that point!

It is highly unikely today, that someone stays in their house for 30 years.

In addition Eddie showed how and why:

  • The investor would also be receiving, if properly structured and negotiated, payments on the BK 13 arrearage account.
  • A portion of this note could be sold to another investor.

We will save those items for future blogs!


Kevin Shortle


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