Yield maintenance is what a lender charges a borrower if the borrower opts to prepay their loan. This fee is meant to compensate the lender for the loss of interest income that they will incur as a result of the loan being paid off early. While yield maintenance is generally a good thing for lenders, it can be costly for borrowers.
Here’s what you need to know about yield maintenance and how to calculate it, so you can make more informed investment decisions.
What is Yield Maintenance?
Yield maintenance is used by lenders to recoup the interest income they lose when a borrower pays off a loan early. This guarantees the lender all the scheduled interest payments. Lenders issue yield maintenance to safeguard the loan’s expected return on investment. Yield maintenance protects the lender’s interest because it places the responsibility of lost interest income on the borrower.
The amount of the fee will depend on several factors, including:
- Interest rate of the loan
- Term of the loan
- Original principal balance of the loan
- Current market interest rates
Yield Maintenance Prepayment Penalty
While you may hear yield maintenance referred to as a prepayment penalty, it’s not really a penalty. Instead, yield maintenance is just a fee that is charged to a borrower if they choose to prepay their loan before the maturity date.
Yield Maintenance vs. Defeasance
Yield maintenance involves the prepayment of a loan and the cost a borrower incurs to do so before the loan reaches maturity. Defeasance is a way to avoid prepayment penalties that involves building a yield-bearing portfolio (like securities or other owned real estate) that is sufficient to cover the debt service of the existing loan.
The result is that the loan is offset indefinitely—but not actually paid off. Ultimately, this lets investors offset the cost of a loan on their books without incurring fees associated with early repayment.
How to Calculate Yield Maintenance
To calculate yield maintenance, you will need to know the following:
- Interest rate
- Treasury yield
- Remaining balance
- Total payments remaining
- Number of annual payments
- Present value of the remaining mortgage balance
With this information, use the following yield maintenance formula:
Yield Maintenance = Present Value of Remaining Payments on the Mortgage x (Interest Rate – Treasury Yield)
Use this formula to calculate the present value of the loan balance:
Present Value = [1 – ((1 + Treasury Yield)-n/12)] / Treasury Yield) x Remaining Balance
Where n = number of months remaining in the loan term
Example Yield Maintenance Calculation
Consider, for example, a real estate investor in San Francisco who wants to pay off their outstanding loan balance with three years (36 months) remaining in the repayment term. The investor was issued a 10-year loan at a 7% interest rate, and there is a remaining loan balance of $1,000,000.
The investor goes to the U.S. Department of the Treasury website and sees that the three-year treasury yield is at 3%. The present value of the loan balance is calculated as follows:
Present Value = [1 – ((1 + 0.03)-36/12)] / 0.03) x $1,000,000
Present Value = 2.828611 x $1,000,000
Present Value = $2,828,611
Based on the present value factor, yield maintenance is calculated as follows:
Yield Maintenance = $2,828,611 x (0.07 – 0.03)
Yield Maintenance = $2,828,611 x 0.04
Yield Maintenance = $113,144.44
This means that the investor will pay an additional $113,144.44 if they choose to pay off the loan within the yield maintenance period.
How Does Yield Maintenance Work?
When a borrower prepays a loan, the lender loses out on the interest that they would have otherwise earned. Yield maintenance ensures that the lender is compensated for this loss.
It’s important to remember that yield maintenance is not a penalty. It is simply a way for lenders to protect their investment. In most cases, yield maintenance is baked into the loan agreement from the start. This means that borrowers should be aware of the potential cost before they agree to the loan.
While yield maintenance can be costly, it is not always a bad thing. In some cases, it may make sense to prepay a loan in order to take advantage of a lower interest rate. Borrowers should always weigh the cost of yield maintenance against the potential savings before making a decision.
Yield Maintenance FAQs
What is a yield maintenance clause?
A yield maintenance clause is a provision in a loan agreement that requires the borrower to pay a fee if they prepay their loan. This yield maintenance fee is meant to compensate the lender for the loss of interest income that they will incur as a result of the loan being prepaid.
What is a yield maintenance period end date?
The yield maintenance period end date is the date on which a borrower can prepay their loan without having to pay a yield maintenance fee.
What is a typical yield maintenance period?
The yield maintenance period is the length of time during which a borrower is required to pay a yield maintenance fee if they prepay their loan. The typical yield maintenance period is 120 days.