A prepayment premium designed to make the lender whole for the interest it loses when a fixed-rate loan pays off early.
The longer version
Yield maintenance is a prepayment premium designed to make a lender indifferent to early repayment. If a borrower pays off a fixed-rate loan early, the lender loses the interest it expected to earn, and yield maintenance charges the present value of that lost interest.
The calculation compares the loan's interest rate with the yield on a Treasury security of matching remaining term. If the loan rate is higher, the lender would have to reinvest at a lower rate, so the borrower pays the present value of the difference over the remaining term. Most loan documents also set a minimum premium, commonly a percentage of the balance, so prepayment is never free.
That makes the cost move with rates. When market rates have fallen since the loan was made, yield maintenance is expensive. When rates have risen to or above the loan rate, it can shrink to the minimum.
It is the common prepayment structure on fixed-rate balance sheet and agency loans. Securitized loans more often use defeasance, which replaces the collateral instead of paying a premium, and many loans include an open period near maturity when the loan can be repaid at par.
Common questions
- What is yield maintenance?
- A prepayment premium that compensates the lender for interest lost when a fixed-rate loan is repaid early. It equals the present value of the difference between the loan rate and a matching Treasury yield over the remaining term, usually with a minimum.
- How is yield maintenance calculated?
- By comparing the loan's interest rate with the yield on a Treasury of matching remaining term, then discounting the difference in interest payments over the remaining term to present value. The exact formula is defined in the loan documents.
- Why does yield maintenance cost more when rates fall?
- Because the gap between the loan's rate and the lower Treasury yield is larger, so the lender loses more by being repaid and reinvesting at current rates. When rates rise, the premium shrinks toward its minimum.
- Is yield maintenance the same as defeasance?
- No. Yield maintenance is a cash premium paid at payoff, after which the loan is retired. Defeasance keeps the loan outstanding and substitutes government securities for the property as collateral.
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