In this video, I’m going to show you the mechanics of discounting a mortgage note.
For this exercise, I’m going to use what’s called a TVM, or Time value of Money calculator. To perform the calculations yourself while following along with me, go to http://www.fncalculator.com/ and call up the TVM calculator under the “finance and investment” tab.
Briefly defined, the “Time value of money” principle holds that cash in hand today is worth more than the same amount of cash to be received at some future date.
So, let’s go right into the example.
Let’s say you want to buy a $20,000 mortgage note, 15-year term, 8% interest. How would you determine the price? Would you pay $20,000? Or, would you pay less? If your investment strategy was to have each invested dollar earn 13%, you couldn’t buy that note for “full price,” since you would only be earning 8% interest.
So, in order to get your 13% return or yield, you would have to pay less than the $20,000. This is the concept of discounting a mortgage note. Though you pay less for the note, the monthly payments aren’t going to change. The payment amount will always be $191.13 every month, as we will see shortly. So, given all of this, the question really is: If you’re receiving payments of $191.13 for 15 years, how much must you pay to get a 13% yield?
The first thing you want to do is calculate the parameters of the original note. We first need to calculate the payment amount.
First, we enter is the number of payments. We know it’s a 15 year term, so that ‘s 15 x 12 months = 180 payments. 180 goes into the ‘periods’ field.
The annual rate of interest on the original note is 8%.
The present value, the amount the note is written for, is $20,000.
Once these three parameters are plugged in, solve for payment by pressing the payment key and you should come up with $191.13.
Calculate the Pmt
This is the note you are buying.
Next, we want to calculate the Present Value of this note at our required yield, which is going to be 13%.. We plug 13 into the ‘annual rate’ field and then calculate the PV.
The PV is the amount you will pay for this cash flow in order to come away with a 13% yield.
And the answer is $15,106.20.
Calculate the PV:
So, by paying $15,106.20 for this stream of payments, you will have a yield of 13% per year. You would present this offer to the seller of this note.
To recap what You Have Learned: Discounting means raising your “yield” in the annual % rate column and then calculating the PV or Present Value to determine the price you will pay for the note.
Discounting a seasoned mortgage note
“Seasoning” means that there is a payment history on the note. In all likelihood, you will be making offers on notes where X number of payments have already been made. So, then, you will need to calculate the number of payments remaining with your desired yield.
Let’s say three years of payments have already been made on the note. Just plug in the number pf payments remaining (144) and then recalculate the present value. You should come up with $13,904.15, and that is the $ amount you will pay for the 144 remaining payments of $191.13 in order to return your desired yield of 13%.
Recalculate the PV:
If there is a balloon payment written into the mortgage note, you will construct your offers by entering the balloon payment amount into the future value field. First, you will need to determine the balloon payment amount, and, for that, we will need an amortization schedule. So, we go to the loan calculator and generate one. Put in the loan amount ($20,000), 8% interest, 15 years—amortization, let’s say the balloon is due in 5 years; go down to payment # 60 and get the balloon amount which is $15,753.28.
Then, go to back to the TVM calculator, plug in the $15,753.28 future value, enter 60 which is 5 years of installments; enter the desired 13% yield, make the payment amount a positive number and then solve for present value which comes out to $16,652.92 which is what you will be willing to pay for this note with a 5 year call.
Recalculate the PV: