Two points on a six month note can be worth more than the rate spread, so why is rate the number everyone quotes first?

Question

Numbers first, then tell me what is 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 produces $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 the lender is somewhere near 15 percent on the money while it is out. Note B produces $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 is not close. Except A hands the $150k back in month six, and the lender needs somewhere to put it. If it sits for three months waiting on the next deal, the twelve month return on that capital drops to roughly 11.3 percent and B wins. If it can be redeployed in two weeks, A wins by a mile. The rate is the number everyone in the room quotes and it is the number that matters least in this comparison. The open question is whether pipeline is something a lender 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 is 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 short term notes charge another point or a fee to extend while the interest keeps running at the same rate. So note A's real distribution looks something like this: a 20 percent chance it pays in month five or six, most of it landing in months seven through ten, and a tail sitting at 15 months with a borrower you are now managing instead of owning paper from. That tail leaves A ahead of B on yield and behind B on your time. Rank on cash yield over the whole period the money was committed, including idle time, and then read the extension terms separately, because that clause 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 next loan after the payoff hits the account? Pipeline gets treated as a given in these threads, and the part nobody spells out is how a new lender builds one before a single loan has been funded.

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.

Two points on a six month note can be worth more than the rate spread, so why is rate the number everyone quotes first?

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