Glossary

Yield Maintenance

Also known as: YM

Globalbiz CRE Academy defines Yield Maintenance as follows: Yield maintenance is a prepayment penalty that compensates a lender for lost interest when a loan is repaid early, calculated as the present value of the interest payments the lender would have received, discounted at a comparable Treasury yield.

How it works

The premise is that a lender priced its loan expecting a stream of interest over a fixed term. Early repayment returns the principal into a market that may offer lower yields, so the lender is worse off. Yield maintenance restores the economics: the borrower pays an amount that, when reinvested at the current Treasury rate, reproduces the interest the lender would have earned.

Its most important characteristic is that the penalty depends on the rate environment rather than on a fixed schedule. When market rates have fallen below the loan's rate, the lender's reinvestment yield is lower and the penalty is large. When rates have risen above the loan's rate, the lender can reinvest at a better yield, and the penalty falls to a floor: commonly 1% of the balance, and occasionally to nothing.

This produces a counter-intuitive but reliable rule. Borrowers usually want to refinance when rates have fallen, which is exactly when yield maintenance is most punitive. In a rising-rate environment refinancing is unattractive for other reasons, but the prepayment penalty is at its cheapest. The penalty is therefore highest precisely when the borrower most wants to pay it.

The mechanics reward attention to detail. The discount rate is usually the yield on a Treasury of maturity matching the loan's remaining term, sometimes plus a stated spread, and the choice materially changes the result. Many loans also carry an open window in the final months when prepayment is permitted without penalty, and a borrower planning a sale can often save substantially simply by timing the closing into that window.

Worked example

A $5,000,000 loan at 6.5% with four years remaining is repaid early. Compare two environments: Treasuries of matching maturity at 4.0%, and at 7.0%. Assume interest-only for clarity and a 1% floor.

StepCalculationResult
Annual interest the lender expected$5,000,000 × 6.5%$325,000
Annual interest on reinvestment at 4.0%$5,000,000 × 4.0%$200,000
Annual shortfall$325,000 − $200,000$125,000
Present value of four years of shortfall at 4.0%$125,000 annuity factor 3.6299$453,738
Penalty if Treasuries are at 7.0% insteadno shortfall; the 1% floor applies$50,000

The same loan, repaid on the same day, costs $453,738 to exit if rates have fallen to 4.0% and $50,000 if they have risen to 7.0%, a nine-fold difference driven entirely by the rate environment. At 9.1% of the balance, the falling-rate penalty would consume most of the benefit of refinancing into a lower rate, which is precisely its purpose.

How it compares

Prepayment structures compared
StructureHow the cost is setTypical lender
Yield maintenancePresent value of lost interest; varies with ratesLife company, agency, bank
DefeasanceCost of buying a Treasury portfolio to replace the cash flowsCMBS
Step-downFixed schedule, e.g. 5% falling to 1% over the termBank, bridge
LockoutPrepayment prohibited entirely for a stated periodOften combined with the above

Common mistakes

Assuming the penalty is small because rates have moved
It is large exactly when rates have fallen, which is when borrowers most want to refinance.
Overlooking the open prepayment window
Most loans permit penalty-free prepayment in the final months. Timing a sale into that window can save the entire penalty.
Ignoring the discount rate definition in the loan documents
Whether the Treasury yield is used flat or with a spread changes the calculation materially.

Frequently asked questions

What is yield maintenance?
A prepayment penalty equal to the present value of the interest a lender loses by being repaid early, discounted at a Treasury yield of comparable maturity, subject to a floor that is commonly 1% of the outstanding balance.
How is yield maintenance calculated?
Take the difference between the loan's interest rate and the reinvestment rate, apply it to the outstanding balance for each remaining period, and discount those shortfalls to present value using the specified Treasury yield. If the reinvestment rate exceeds the loan rate there is no shortfall and the floor applies.
Is yield maintenance the same as defeasance?
No. Yield maintenance is a cash payment compensating the lender for lost interest. Defeasance replaces the property as collateral with a portfolio of government securities that reproduces the loan's payments, leaving the loan outstanding and the property released.

Related terms

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