Buying Mortgage Notes: 7 Tips for Calculating Cash Flow Notes

If you plan on selling or buying mortgage notes the pricing will eventually come down to some important cash flow calculations.  If you get cold chills or high school flash backs thinking about math you can always leave the number crunching to the note buyers. However, I challenge you to get outside your comfort zone and give these exercises a try.

Why? Well knowledge is power and you will be able to know if you are getting a fair (or not so fair) deal when selling mortgage notes.

1. Five Calculator Key Strokes for Buying Mortgage Notes

The first step is to grab your favorite financial calculator or software program.  Personally I use the HP12C but you can read this article on Choosing the Best Financial Calculator and decide for yourself.

Once armed with your financial calculator of choice, the functions are basically the same. They all utilize five primary keys, which are normally located in the first or second row of the calculator. Here is what they look like and what they mean:

• N = Number of Payments

• I = Interest or Yield/Return

• PV = Present Value of Cash Flow or Loan Amount

• PMT = Payment

• FV = Future Value

The easiest way to get started is to grab a piece of paper and make columns for the five keystrokes. You’ll find it helpful to write the values down before putting them in the calculator (plus it helps avoid some common mistakes). It will look something like this:

 

When we are looking for a solution to one of the categories, we need only place values in the known categories and the calculator will solve for the unknown category.

2. Calculating Owner Financed Mortgage Payment Amount

Let’s say that you are looking at selling a house with owner financing for $120,000 with a $20,000 down payment resulting in a $100,000 mortgage note. You want payments amortized over 30 years (360 months) with a 10% interest rate. If we start by charting this on paper first, it will look like this:

 

The first thing you may have noticed is that PV is a negative number. The calculator must be told which dollars are going “out” and which dollars are coming “in.” This is typically from the investor’s perspective so they are lending or carrying back a note for $100,000. The positive money (for the investor) will be the payments that come in.

(Special Note: Be sure you have checked the instructions that came with your calculator. If you have elected to go with the HP12C, you will have learned that you must enter the 10% in “I” as 10 [G] [I].  The HP12C needs to be told to divide the 10% into monthly increments – most other calculators will do this automatically and you will only need to enter “10” into I.)

Once we have entered in the numbers from the chart into the calculator, we need only solve for the missing category [PMT] to calculate our answer.

 

Payment Answer = $877.57 per month

3. Calculate Term For Seller Financed Mortgage Notes

Now let’s solve for the number of payments or term instead of the payment amount. Assume someone calls and says, “I am going to receive payments of $877.57 each month. We had a starting balance of $100,000 and the interest rate is 10%. I just don’t know how long it will take to get paid off.”

We can show this as follows:

 

Remember, we start with what we know. We know the interest [I], we know the starting balance of the note [PV], we know the payment [PMT], and we know that there is no balloon [FV]. Now we need only take the numbers from the table and add them to their correct categories in the calculator. If we have done that, we get the following answer:

 

Term Answer = 360 months

4. Calculating Note Buyers Purchase Price

Now, let’s go back to our first example to look at buying a note and establishing a pay price. To recap it looks like this:

 

Most amortized notes have a final payment that is slightly more or less than the stated monthly payment. To obtain exact figures, it is necessary to calculate this trailing amount by solving for the future value [FV] of that final payment as follows:

 

Solve for future value [FV]:

 

Future Value Answer = 3.55

When the answer is a positive number it represents that the final monthly payment will need to be increased. In this case the final monthly payment would be $877.57 plus $3.55 for a total of $881.12. If the answer is a negative number it means the final payment would be less than a full payment amount.

If you skip this step of solving for the final payment difference, your answers to the following calculations will have slightly different results. The overall effect on yield will be nominal, but the figures can differ by a couple of dollars and cents.

Let’s say that you want to purchase the above note and want to earn an 11% return or yield. The first thing you will notice is that we do not have to change every category. In fact, it is better if you don’t. With the above calculation still in the calculator, take a look at what we are trying to calculate on the next table:

 

You will notice we don’t have to change all the numbers. The ONLY number we need to change is [I]. We simply put an 11 in [I] and calculate for PV to get the following:

 

Present Value Answer = $92,150.55 Purchase Price

In other words, if you pay $92,150.55 for the right to receive $100,000 payable in 360 payments of $877.57, you will receive an 11% return on your investment.

Want to earn 12% instead? Here is what the chart would look like:

 

Again, we only need to change the number in [I] to 12% and now calculate for PV.

 

Present Value Answer = $85,315.99 Purchase Price

In other words, if you pay $85,315.99 for the right to receive 360 payments of $877.57, you will receive a 12% return on your investment.

Understanding Discounted Notes

You can see that the “note discount” really comes from the difference between how much the investor wants to earn (yield) and how much the note is already earning (face rate).

The greater the disparity between the yield and face rate, the greater the discount.

The closer together the yield and face rate, the smaller the discount.

If we wanted to earn 10% as a note buyer, we would pay $100,000 for the note (in real life you would have what is called a “minimum discount” to help cover closing costs when purchasing notes). You can see as we increase our yield requirement from 10% to 11% to 12% the “pay price” continues to go down. We are paying less money for the same cash flow – thus the note buyer return is higher.

5. Calculate Yield When Buying Mortgage Notes

What if we know the pay price but want to calculate for yield? We are simply solving for [I]. Keeping with the same example, we plan to invest $87,000 but want to know our return:

 

The [PV] category is replaced with the known value of $87,000 and we solve for [I]:

 

Interest Answer = 11.74% Yield

The yield or return on the $87,000 investment for this cash flow would be 11.74%. (If using the HP12C the answer for [I] is .98 per month, which must be multiplied by 12 to express as an annual rate.)

6. Calculating Current Balance on Cash Flow Notes

Suppose someone wants to sell a note but has already been receiving payments for 5 years or you just want to know the current balance on a seasoned mortgage note. The monthly payment of $877.57 represents both the principal and interest on the owner financed note, which will amortize or pay off in 30 years (360 payments). Each month the balance goes down and the remaining term is reduced. To calculate the remaining principal balance after 5 years or 60 payments use these values:

 

Solve for FV and you will get:

 

Future Value Answer = 96,574.44 Remaining Principal Balance

This remaining cash flow of $96,574.44 payable at 10% interest with 300 payments left will be now be the basis for calculating the Note Buyers Purchase Price and Yield.

Want a Calculating Cash Flow Notes Challenge?

What amount would a note buyer offer for this seasoned note if they desired a 12% yield? (Hint: Return to #4 above and replace the values with the updated information).

Need a little incentive?

Just post your answer below and we will email you a handout on Mastering Partials for Maximum Profits. (This offer is valid for all comments posted and will apply for both right and wrong answers!)

7. Common Mistakes When Calculating Cash Flow Notes

If you calculated the correct answers in these examples, then congratulations! If not, don’t worry. What you need to do now is simply “recall” the various categories and determine where you have a wrong number in a category (this is why it is helpful to write down the calculations first on paper). Here are a couple of things that can help you out:

Was PV entered as a negative number?

Remember, the calculator needs to know “money out” and “money in.” That is how it can figure out a yield or interest rate. So, for purposes of keeping it simple, we always use the investors’ side and make PV the negative money going out and PMT the positive money coming in. (This is accomplished by using the – sign of the [+/-] key on the HP10B or the Change Sign [CHS] on the HP12C.)

Wrong Payments per Year?

Most of what you do will be 12 payments per year. That is something we have to tell the calculator. If for some reason you want to change your calculator to quarterly payments or annual payments (see your calculator manual), then you have to make sure you switch it back when you are done.

Incorrect input?

When you make a mistake, use the “recall” key. This allows you to check the input in each category without changing them all. When you make a mistake, you may feel like you want to clear everything and start over – it is often easier if you use the “recall” key, find the error, and just change that category.

Old number in the wrong category?

There might have been a number from a prior calculation left in [FV] or some other category by mistake. When starting calculations on a completely new transaction or cash flow, be certain to use the clear all key or key equivalent on the calculator. This avoids carrying any numbers over from prior calculations.

Receiving an Error 5 Message?

This usually means that there are too many unknown categories to solve the equation. Carefully review input to verify the categories contain the correct information. If you continue to receive this error message, it could indicate the cash flow never pays off at the interest and payment provided.

Looking for More Great Tips On Selling and Buying Mortgage Notes?

Of course these calculations just touch the surface of note buying options. There are also:

• partial purchases
• balloon mortgage note payments
• interest only notes
• schedule B for early partial payoffs, split partials
• ITV implications, and more.

Ready to master the financial calculator for maximum profits? Check out our How To Calculate Cash Flows Training for over 50 step by step videos like the one shared here!