Discount Rate

The discount rate is the interest rate an investor uses to convert future expected cash flows from a mortgage note into their present value — what those future dollars are worth today. It represents the investor's required rate of return: the minimum annualized yield they need to earn in order to justify tying up capital and bearing the risks of a particular note. A higher discount rate produces a lower present value (and a lower bid price); a lower discount rate produces a higher present value (and a higher bid price). Selecting the right discount rate is one of the most consequential decisions in note pricing — it directly determines what you should pay.

The Mechanics of Discounting

The core idea behind the discount rate is the time value of money: a dollar received today is worth more than a dollar received a year from now, because today's dollar can be invested and earn a return. The discount rate quantifies that difference.

For a performing loan with predictable monthly payments, the present value calculation discounts each future payment back to today:

Present Value = Payment / (1 + r)^n

Where r is the discount rate per period and n is the number of periods until the payment is received. The sum of all discounted payments equals the net present value of the note — the maximum price an investor should pay to achieve their target return.

The same stream of payments is worth dramatically different amounts depending on the return the investor demands. This is why two buyers can look at the same note and arrive at very different bids — they are applying different discount rates based on their own risk assessments, opportunity costs, and return requirements.

How to Select a Discount Rate

There is no single correct discount rate. It is a judgment call that should account for multiple risk factors:

• Risk-free baseline. Start with the yield on a comparable-maturity U.S. Treasury bond. This represents the return available with virtually zero credit risk. As of early 2025, 10-year Treasury yields sit around 4.5%.
• Credit risk premium. The borrower on a mortgage note is not the U.S. government. Add a spread to account for the probability of default, the borrower's payment history, and their credit profile.
• Collateral risk. The property's condition, location, and LTV ratio affect recovery in a worst-case scenario. Weaker collateral demands a higher discount rate.
• Liquidity premium. Mortgage notes are illiquid — you cannot sell one in minutes the way you sell a stock. This illiquidity requires compensation in the form of a higher required return.
• Servicing and operational costs. The ongoing cost of servicing, legal work, and asset management erode net cash flow and should be reflected in the rate.
• Foreclosure timeline. A note secured by property in a state with a 6-month non-judicial foreclosure process carries less timeline risk than one in a 36-month judicial state.

In practice, most note investors apply discount rates in the following ranges:

Discount Rate vs. Note Rate

The discount rate and the note's contractual interest rate are different concepts that are often confused:

When the discount rate equals the note rate, the note is priced at par — the investor pays roughly the remaining unpaid principal balance. When the discount rate exceeds the note rate, the note trades below par (at a discount). When the discount rate is below the note rate, the note trades above par (at a premium).

Applying the Discount Rate to NPLs

For non-performing loans, the standard present value calculation breaks down because there are no reliable future payments to discount. Instead, investors use a scenario-weighted approach: estimate the probability and expected cash flow from each possible resolution (workout, discounted payoff, foreclosure, short sale), discount each scenario's cash flows at the target rate, and weight the results by probability. The resulting figure — sometimes called the Investment Current Target Value — becomes the investor's maximum bid.

Even in this framework, the discount rate remains the lever that adjusts for risk. A note with a clear path to resolution and strong equity justifies a lower discount rate. A note with uncertain title, a contested lien position, or a property in poor condition demands a higher one. The discipline of explicitly choosing and defending a discount rate forces the investor to quantify risk rather than rely on gut instinct — which is why yield-based pricing, anchored by the discount rate, remains the most rigorous approach to note valuation.