Yield Maintenance

What Is Yield Maintenance?

Yield maintenance is a prepayment penalty built into some loans, most often commercial mortgage loans, that a borrower pays if they repay the loan before its scheduled maturity. Its purpose is to protect the lender's expected return. A lender prices a loan based on the interest it expects to collect over the full term. If the borrower repays early, the lender must reinvest that money, often at lower prevailing rates, and would earn less than planned. The yield maintenance charge is meant to make up that shortfall, so the lender ends up in roughly the same economic position as if the loan had run to term.

How It Is Calculated

Lenders word their documents differently, but the charge generally works along these lines:

Yield maintenance charge = present value of remaining scheduled payments, discounted at the reinvestment rate, minus the outstanding principal balance

The reinvestment rate is usually tied to a benchmark such as a U.S. Treasury security with a comparable remaining term. When market rates have fallen since the loan was made, the remaining payments are worth more when discounted at the lower rate, so the charge is higher. When market rates have risen, the charge can be small or even zero, because the lender can reinvest at a better rate. Some agreements set a minimum charge, and the exact formula varies from one loan to another.

Why It Matters to Investors

Yield maintenance matters mainly to investors who hold or analyze commercial loans and mortgage-backed security pools. By discouraging early repayment, it makes the cash flows from these loans more predictable. Borrowers who refinance during a period of falling rates face a larger cost, which can change the timing of expected income for those who hold the loan. Yield maintenance is often compared with defeasance, a different approach in which the borrower replaces the loan's collateral with Treasury securities that produce the same payment stream. Reading a loan's prepayment terms closely is the most reliable way to know which method applies.