Financial Analysis of a Loan Settlement
When a borrower settles with the lender, the borrower is actually buying the loan from the lender. For example, if the borrower settles at a price of $8k on a $100k loan, the borrower buys that loan for $8k.
The borrower, now the note owner, is entitled to receive the original promissory note, endorsed by the lender, with that endorsement stating “paid in full” or words to that effect, along with the signature of an authorized employee of the lender, typically an officer. Depending on the state’s procedures, the lender will also sign over and deliver that deed of trust.
The borrower, now owner of the loan, will instruct the trustee to re-convey the deed of trust (in trust deed states). The procedure will vary slightly in the mortgage states.
ROI of the Settlement
The return on investment calculation for a settlement gives us a fun result. Albeit an exaggerated one. Caveat: ROI is best used in comparing alternative investments under consideration by the investor. As such, it’s not a realistic measure of return on one specific investment. Here’s the formula.
ROI = (Gain from the Invest. – Cost of the Invest.) / Cost of the Invest
In our example above, the gain from our investment = $100k (the note balance).
The cost of our investment is $8k (what we paid to buy the note).
Therefore, ROI = ($100k - $8k) / $8k = 92 / 8 = 11.5
Convert that to a percentage by multiplying by 100 and we get 1,150 %.
Let’s also look at it from a loan calculation perspective. Let’s say that the $100k loan is at a 6% interest rate, amortized over, and due in, 15 years. The monthly payment amount is $843.86. Round that to $844.00. The total payments over the 15 yrs = 12 x 15 x $844 = $151, 920. The amount of interest paid portion of this total will be less if the term is shortened by the borrower repaying the loan sooner than 15 years.
Let’s pretend that the loan runs its term of 15 years. The $8k spent to buy the loan would result in a savings of over $150k. That’s an ROI of 150 / 8 = 1,875 %.
A caveat. While on the surface, paying a higher price, say 20 – 30 % for a settlement, will also yield a very good ROI, those prices aren’t competitive, and are unnecessarily expensive. Why? Because a lender can sell a non-performing 2nd loan on the secondary loan market for only 2–5 %. So then, why would a borrower pay more than 5– 10 %?
The only reasons to pay more that come to mind are: 1) when the 2nd is in the money and that lender might soon foreclose, or 2) when the borrower is anxious to settle ASAP. In the first instance, the borrower may need to be less demanding in negotiations, as he/she has much less leverage. In the second instance, the borrower will pay more for his/her lack of patience.
The “Cash on Cash” Measure of Return
For a more realistic measure of return, let’s look at “cash on cash” (COC), a ratio frequently used by commercial RE investors. COC, also known as the Equity Cap Rate (Capitalization Rate), is the return on $$ the investor “personally” invests, as in cash down payment and closing costs. COC is also known as the Gross Spendable Income (GSI) or Net Cash Flow per year divided by the cash invested. Here’s the formula. COC = GSI/ $$ Invested.
In our example, we use GSI to represent the sum of the annual payments we’ve saved as income received, e.g. $844 x 12 = $10,128, divided by the money we invested, $8,000.
$10,128 / $8,000 = 1.2660 = 127%.
Needless to say, this is indeed a very good return!