In the real estate industry, lenders make money through fees and interest. Anything that threatens a lender’s expected cash inflows can cause a drop in the return on investment, which means less money in the lender’s pocket. Yield maintenance is a legal provision that real estate lenders routinely incorporate into their contracts. Its purpose is to reimburse the lender for lost interest income when a borrower pays off a mortgage early due to falling interest rates.
The Lender's Cost of Prepayment
Lenders expect a specified return, or yield, on the money they lend. In the mortgage market, homeowners have the option to refinance their mortgages when interest rates fall. That’s good for the homeowners but creates a problem for lenders.
Read More: How to Determine the Yield on a Conventional Loan
The lender’s problem is that the interest rate at which the lump sum payment they receive when a prepayment occurs will be lower than that of the original mortgage, due to falling interest rates. When they receive the lump sum, lenders know that, at the very least, they can reinvest it in two-year Treasury notes to earn the current, lower interest rate on top-quality debt. This reduces the yield on the original loaned amount because part of it will now be earning a lower interest rate.
Naturally, the mortgage lender will look to redeploy the prepaid money in subsequent mortgage loans. However, the standard convention is for the yield maintenance penalty to use the Treasury note interest rate as the basis of measuring the potential lost yield.
Thus, the yield maintenance penalty plugs the gap between the new yield and original one. It is an additional sum of money added to the payoff amount that the homeowner pays when refinancing a mortgage.
How to Calculate Yield Maintenance
The size of the yield maintenance fee is the difference in the present values of the earnings on the mortgage with and without the prepayment.
The calculation is:
Yield Maintenance Fee = (C -R) x F x B
- C is the loan interest rate,
- R is the current Treasury note yield,
- F is the present value factor and
- B is the unpaid loan balance as of the prepayment date.
F, the present value factor, recognizes that money is worth more when it’s in hand today rather than at a future date – that’s why lenders charge interest in the first place. The present value of a cash flow stream is how much it would be worth if today you collected it all at once.
Read More: How to Calculate the Present Value of a Bond
The value of F is equal to (1 - ((1 + R)^-N/12)))/R, where N is the number of months. This formula discounts the stream of future interest cash inflows by the current Treasury note rate to provide the present value of those inflows.
Using a Yield Maintenance Calculator
You could calculate the yield maintenance penalty by plugging all the numbers into the equation. Fortunately, a spreadsheet or online yield maintenance calculator makes the job much easier.
To take an example, imagine a homeowner decides to refinance her 30-year, 4.5 percent mortgage after 10 years because interest rates have fallen. The original mortgage loan amount was $300,000, of which $243,778 remains. Assume that the current two-year Treasury note yield is 2.2447 percent.
Read More: Treasury Rate Definition
By entering these numbers into a yield maintenance calculator, we find the present value of the lost interest is $55,653, using the most common calculation method. In this case, the homeowner would need to make a lump sum payment of ($243,778 + $55,653) or $298,606, when refinancing the mortgage, clearly a distasteful prospect. For this reason, borrowers should understand the prepayment penalty, if any, built into a loan contract before signing.
Comparison to Defeasance
Defeasance is sometimes used in commercial real estate loans instead of yield maintenance to compensate a lender for lost interest due to prepayment. Under defeasance, the borrower doesn’t use the proceeds of refinancing or selling the mortgaged property to repay the lender in a lump sum. Instead, the borrower invests the proceeds, known as the defeasance collateral, in Treasury debt that matures at the same time as the original mortgage would have.
The lender receives the interest paid by the Treasury debt in lieu of the original mortgage interest. If interest rates have fallen, the borrower will have to buy additional Treasury debt (known as the defeasance premium) to compensate for the lower yield. In any case, the lender receives the defeasance collateral when the Treasury debt matures.
Eric Bank is a senior business, finance and real estate writer, freelancing since 2002. He has written thousands of articles about business, finance, insurance, real estate, investing, annuities, taxes, credit repair, accounting and student loans. Eric writes articles, blogs and SEO-friendly website content for dozens of clients worldwide, including get.com, badcredit.org and valuepenguin.com. Eric holds two Master's Degrees -- in Business Administration and in Finance. His website is ericbank.com.