Yield Maintenance

Yield maintenance is a prepayment penalty type, which helps the investor to reach the yield similar to the situation if the borrower made all the interest payments that were foreseen by the plan before the maturity date. Yield maintenance involves paying by the borrower the rate differential between the interest rate on the loan and the prevailing interest rate in the market on prepaid funds for the length of time remaining until the loan is repaid.

The purpose of yield maintenance premiums is to ignore prepayment by investors (closing the debt before the maturity date). In addition, this makes the refinancing instrument disadvantageous for the borrower and reduces its attractiveness. Yield maintenance is a form of compensation for the loss of interest due to the prepayment of a loan that borrowers pay to lenders.

Understanding Yield Maintenance

The borrower pays interest for use of money to a lender at a specified frequency for a certain period of time if the financing was made, for example, through the issuance of bonds or a loan. For the lender who predicts his profit, the expected interest is considered to be the rate of return.

If some investor buys a 10-year bond, face value of which is $10,000, and its coupon rate is 6% per year, he will be charged 6% x $10,000 = $600 annually. As for the bank that approves $100,000 at a fixed interest rate, it plans to receive interest payments every month until the borrower completes the mortgage payment.

In cases where the borrower repays the loan before the loan repayment period, there is a threat associated with the premature repayment of the principal, also called the prepayment risk. Every debt instrument has this risk, and lenders face this problem from time to time. This type of risk is associated primarily with the shortfall in the expected interest income by the lender for the period in which these receipts were planned.

The most common reason for early repayment of a loan is a decrease in interest rates, which creates an opportunity to refinance the borrower's debt at a lower interest rate. The prepayment commission, namely the yield maintenance, is designed to compensate the lender for cases when the borrower repays ahead of schedule. In essence, yield maintenance helps the lender to have a planned income without any loss.

The commercial mortgage sector is the most popular area for yield maintenance. Assume that a building owner took out a loan for purchasing a neighboring plot for a period of 30 years. After 5 years since the opening of the loan, interest rates have dropped significantly, in connection with which it was decided to refinance this loan. So, he borrowed money from a second lender and paid off his old mortgage. With the establishment of a yield maintenance premium, the bank that issued this loan can receive the same cash flow as in the case of paying all payments according to the schedule during the entire loan term.

Yield Maintenance calculation example

To determine a yield maintenance, premium is required to multiply the present value of remaining payments on the mortgage by the difference between interest rate and treasury yield.

As an example, the borrower has a loan balance of $50,000; its interest rate is 10%; the remaining term of the loan is 3 years, i.e. 36 months. The decision to repay the loan was made at the time of the fall in the yield of 5-year treasury bonds to the level of 5%.

The 1st step is finding the present value factor: = [(1 – (1.05)-36/12)/0.05] x $50,000 = 2.72 x $50,000 = $136,162.40

The 2nd step is determining yield maintenance: = $136,162.40 x (0.1 – 0.05) = $6,808.12

Accordingly, in order for the borrower to be able to repay his debt ahead of schedule, he will need to pay an additional $6,808.12.

The lender can make a profit if the Treasury yields increases compared to the yield it had at the time the loan was taken.