What is Yield maintenance?
Definition of Yield maintenance
A prepayment premium or penalty that allows investors to have the same yield if borrower had paid all scheduled mortgage payments and loans until maturity. Yield maintenance penalties are designed to make lenders indifferent to an early prepayment by a borrower. On the other side, it can be interpreted as if a borrower currently has a 6.5% rate on its mortgage with 5 or 6 years to go until maturity, at this time the penalty could well be huge.
Explanation of Yield maintenance
Suppose a 15-year interest-only $1,000,000 mortgage at 4%. The borrower decides to refinance after the 5th year. The yield maintenance prepayment penalty would equal the difference between the current 4% rate and the yield that the bank would receive reinvesting the loan proceeds in a 10-year Treasury Note. (10 years being the remaining term of the loan). Let’s keep the example simple by assuming that at the time of prepayment, the 10-year Treasury note rate is 5%. The borrower then would require paying the present value of 2% difference for each year over the loan’s ten remaining years, or $200,000 to the lender. This premium will make the lender “whole” and insure that the lender will not experience an economic loss as a result of being paid prior to the loan’s maturity. The same formula also applies to amortizing loans, however it is much easier to illustrate with an interest-only loan. With a minor variation each lender will have same formula, however the above example shows the spirit of the yield maintenance penalty.