Fund managers have a lot to think about when it comes to investing in mortgage notes, whether performing loans (PL) or nonperforming loans (NPLs). In this post, we’ll break down the nitty-gritty of mortgage note accounting, so you can invest with confidence.
First, let’s define performing and non performing mortgage notes. Performing notes are loans that are current or close to current. NPLs are loans that are in default or are at risk of default. In other words, they are loans where the borrower has stopped making payments or is likely to stop making payments.
When investing in notes, it’s important to account for them properly. This involves understanding the different accounting methods and how they apply to these assets. Generally Accepted Accounting Principles (GAAP) provide guidance on accounting for performing and nonperforming loans.
The first thing you need to consider is the classification of these assets. Performing notes can be classified as either held-to-maturity, available-for-sale, or trading security. Non-performing loans are generally classified as available-for-sale. The classification of these assets will determine how they are accounted for on the balance sheet and income statement.
Held-to-Maturity
You plan on holding the mortgage note until it fully matures, or is paid off in full
Available-for-Sale
You do not intend to hold the note until maturity, but instead intend to sell it
Trading Security
This is a classification of mortgage note that is bought and sold frequently for short-term profits
If you plan on holding a mortgage note until it matures, it can be classified as held-to-maturity. This means that it’s carried on the balance sheet at cost, and any interest earned is recognized on the income statement.
If a mortgage note is classified as available-for-sale or trading security, it’s carried at fair value on the balance sheet, and any changes in fair value are recognized in other income. It’s important to establish the fair value of these notes (aka Fair Market Value) to make sure your accounting is accurate.
If a performing note is purchased at a discount, a schedule must be maintained to track the amortization of the discount. For example, assume that a note is purchased at a 10% discount and the P&I on the note is $100/mo. If the breakdown of this month’s P&I is $50 of interest and $50 of principal, the $50 of interest is classified as “interest income”, but another $5 of the principal is classified as income as well (i.e. 10% of the $50 principal payment) while the remaining $45 of principal payment is received as a reduction in the cost-basis of the note.
Stay tuned for our next post, where we’ll dive into establishing the fair value of these notes.
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