The Dreaded Schedule B

The following description requires you to use your calculator. It will take you about an hour and half to read, understand and the do the problems. However, if you take the time to do so you will understand a concept only advanced cash flow buyers bother to work out. It is worth the effort.

ne of the most conceptually difficult things for some note buyers to understand is what happens in the event of an early pay off on a note when you have purchased only a part of the note.

The easy answer to the question is this: You send a contract to the note seller indicating how many payments you are buying. This contract is accompanied by an amortization schedule indicating the exact balance you, the note buyer, will receive on any date that the note is paid off. The amount left from the check the Note Payor pays will go back to the note seller.

Partial purchase-early payoffs are best understood if you understand something about the amortization schedules that are generated when you buy a note. There are three people in any note purchase. The Note Buyer, that is you, the one who purchased the note. The Note Seller, that is the one who calls you to sell you the note. The Note Payor, that is the one making the payments on the note. As you know, an amortization schedule is a list of all the payments to be made on a note. This list shows each payment, the date that payment is due, the amount of that payment that will go to principal, the amount to interest, and the balance due on any particular date.

Typically, Schedule A is the amortization schedule that shows the payments that the payor is making at the face interest rate of the note. No matter who buys or sells the note, the payor will only care about, and be responsible for, this Schedule A.

Schedule C is the schedule for the note buyer. If you are the note buyer, and buy part of the note at a 24% yield, you must have a schedule that shows how much interest you are receiving at each payment, and how much of the payment is your return of the capital you invested, or the principal. The Schedule C will also show what the payoff would be at any payment if you wanted to receive your full 24%. Somewhere in your note folder you must have a Schedule A and a Schedule C. The early -payoff amortization schedule can be one of two types. The first is a simply Schedule C. It shows the balloon amount you will be paid to maintain the yield at which you bought the note. For example, if you bought 90 payments of a 180 payment note for a 24% yield, you would attach an amortization to your purchase contract showing a payoff at any single payment. This payment would maintain your 24% yield.

If you were offered the following note:

N I/Y Pmt PV FV

180 12 134.42 11200 0

You could buy 90 payments at a 24% yield for:

90 24 134.43 ? 0

You would pay PV = $5,590 for the right to receive the next 90 payments. You would turn the note back to the payor at the end of the 90 months. There would then be a balance due of:

90 12 134.43 11200 7952.34

The balance due is FV = $7,952. However, if the note payor decided to pay the note offer after you had received 12 payments he would write a check for:

12 12 134.43 11200 10915.67

FV = $10,915.67. On a normal early payoff how much do you, the Note Buyer, get? And how much does the Note Seller get from this check? For this we will use Amortization Schedule C. You want to maintain your 24% yield, so you would get:

N I/Y PMT PV FV

12 24 134.43 5590 ?

Solve for FV and you get $5,286.72 and the Note Seller would get the remainder. This is somewhat less than the balance of $7,952 he had been expecting if the note went to maturity, but he got the money 6 ½ years sooner.

Many sophisticated note buyers, and most institutional note buyers, however, would prefer to use the more profitable Schedule B attachment to the contract. This Schedule B will give you a higher yield the sooner the Note Payor pays off the Note. It is this Schedule B that gives some people trouble. In fact, in our note classes we have taken to calling this the “Dreaded Schedule B”. Someone said, “if your own money is involved your IQ goes up about 20 points.” So it is worth the effort to understand the following explanation.

Schedule B is a much fairer and a more profitable way to handle this early payoff. This amortization schedule is generated by putting into your calculator the number of payments you are buying, the face interest rate of the note, the amount of the payment the Note Payor is paying and then calculating the present value. This Present Value figure is the present value of the payment you have purchased. This figure will be for more than you paid for the note.

N I/Y PMT PV FV

90 12 134.43 ? 0

The PV is $7,953. This is the Present Value of the 90 payments at the 12% face value of the note. It is more than the $5,590 you paid for the note and the difference represents the profit you have made on your purchase if the note were to be paid off immediately.

Consider the following scenarios if the note is paid off after 12 and 48 months. We will compare Schedule B profits to the less profitable Schedule C profits.

12 month early payoff.

Schedule A: The Payor’s Schedule

N I/Y PMT PV FV

12 12 134.43 11200 ?

The payoff amount from the payor is FV = $10,915.

Schedule B: The original PV is the PV of the payments we have purchased at the face value of the note. (See above)

N I/Y PMT PV FV

12 12 134.43 7953 ?

The payoff we will receive is FV = $7,256. The remainder of the payor’s check will go to the Note Seller.

Schedule C: The original PV is the amount we paid for the note.

N I/Y PMT PV FV

12 24 134.43 5590 ?

The payoff under this schedule is FV = $5,286.72. The remainder of the Note Payor’s check will go to the Note Seller.

We make almost $2,000 more if we use Schedule B rather than Schedule C.

48 month early payoff.

Schedule A

N I/Y PMT PV FV

48 12 134.43 11200 ?

The payoff amount from the Note Payor is FV = $9,827.46.

Schedule B: PV is the PV of the payments we have purchased at the face value of the note. (See above)

N I/Y PMT PV FV

48 12 134.43 7953 ?

The payoff we will receive is FV = $4,591.87. The remainder of the Note Payor’s check will go to the Note Seller.

Schedule C: PV is the amount we paid for the note.

N I/Y PMT PV FV

12 24 134.43 5590 ?

The payoff under this schedule is FV = $3,795. The remainder of the payor’s check will go to the Note Seller.

We make almost $796 more if we use Schedule B rather than Schedule C.

So now, we hope, you can see that understanding and using the Schedule B approach to partial purchases is very profitable. It is the standard in the industry, and is used by most institutional note buyers and sophisticated brokers.

Schedule B: Exercises

1. You are offered a $23,000 with the following terms: 33 months, 10%, Payments of $191.67 per month with a balloon of $23,000.

You agree to buy the payments only for a 32.41% yield.

How much will you receive if the note is paid off at the 16th Payment?

2. You are offered a $100,000 with the following terms: 360 months, 10%, Payments of $877.57 per month. It is fully amortizing.

You agree to buy the next 60 payments for a 25% yield.

How much will you receive if the note is paid off at the 10th Payment?

3. You are offered a $55,000 with the following terms: 60 months, 11.75%, Payments of $538.54 per month with a balloon of $55,000.

You agree to buy the payments only for an 18% yield.

How much will you receive if the note is paid off at the 11th Payment?

4. You are offered a $96,000 with the following terms: 72 months, 11%, Payments of $880 per month with a balloon of $96,000.

You agree to buy the payments only for a 29% yield.

How much will you receive if the note is paid off at the 50th Payment?

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