2 points on a 6 month loan is worth more than the rate spread, so why does everyone quote rate first?

Question

Numbers first, then tell me what's wrong with them.

Note A: 11 percent, 2 points, 6 month term. Note B: 12.5 percent, 1 point, 12 month term. Both $150k, interest only, paid monthly.

Note A: $8,250 of interest over six months plus $3,000 in points, so $11,250 on $150k in half a year. Annualize the points and I'm somewhere near 15 percent on the money while it's out.

Note B: $18,750 of interest plus $1,500 of points, so $20,250 over a full year, about 13.5 percent.

So A looks better and it isn't close. Except A gives me back $150k in month six and I have no idea what I'm doing with it. If it sits for three months waiting on the next deal, my twelve month return on that capital drops to roughly 11.3 percent and B wins. If I can redeploy in two weeks, A wins by a mile.

The rate is the number everyone in the room quotes and it's the number that matters least in this comparison. What I can't tell is whether pipeline is a thing you can actually count on or whether assuming instant redeployment is the same kind of optimism as assuming a flip sells in 90 days.

How do you rank two notes?

dpatel_re · Answer

Your math is arithmetic and it's fine. The part you left out is that a six month term is not a six month loan. Short paper pays off late more often than it pays off early, and the extension is where the yield actually shows up, since most notes I've seen charge another point or a fee to extend and the interest keeps running at the same rate.

So note A's real distribution is something like: 20 percent chance it pays in month five or six, most of it lands in months seven through ten, and a tail sits at 15 months with a borrower you're now managing instead of owning paper from. That tail doesn't make A worse than B on yield. It makes A worse on your time.

Rank on cash yield over the whole period you committed the money, including idle time, and then look at the extension terms separately, because that's the clause that decides whether a late payoff is income or a problem.

aaron_fitz10 · Answer

What does redeploy actually look like in practice? Are you sitting on a list of three borrowers who each want money next month, or are you finding the deal after the payoff hits your account? I keep hearing about pipeline like it's a given and I can't picture how you build one before you've ever funded anything.

omar_haddad · Answer

On my side of it, nobody has ever finished in six months. Price the extension, ledger, that's your real second point.

2 points on a 6 month loan is worth more than the rate spread, so why does everyone quote rate first?

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