Yield maintenance is a prepayment penalty designed to ensure investors achieve their anticipated yield even if the borrower settles their debt earlier than the scheduled maturity date. This requires the borrower to compensate the lender for the interest differential between the loan’s interest rate and the current market rate until the maturity date, ensuring the lender doesn’t lose expected income.
Yield maintenance premiums ultimately make investors indifferent to prepayment and discourage borrowers from refinancing in cheaper interest rate environments.
Key Takeaways
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Guaranteed Yields: Yield maintenance is a method borrowed to lenders to secure losses caused by premature loan or bond prepayment.
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Lender Security: It mitigates prepayment risk or inhibits early debt settlement by borrowers.
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Calculation Formula: The yield maintenance premium is calculated using:
YM = PV of Remaining Payments on the Mortgage x (Interest Rate - Treasury Yield)
Understanding Yield Maintenance
When lenders provide loans or buy bonds, they expect periodic interest payments as compensation for granting funds. For example, if an investor buys a 10-year bond valued at $100,000 with an annual coupon rate of 7%, they plan to receive $7,000 annually. Similarly, banks that issue mortgages expect uninterrupted interest payments over the loan’s term.
Prepayment occurs when borrowers pay off loans early, resulting in prepayment risk, which cuts lenders’ expected interest income short. Yield maintenance ensures lenders receive equivalent compensation up to the maturity date, making premature repayment unattractive for borrowers.
Yield maintenance is prevalent in the commercial mortgage industry. Imagine a property owner with a 30-year loan, faced with lower interest rates five years into the term. By refinancing, the borrower pays off the original loan, potentially causing a yield maintenance premium from the lender to recover interest income losses.
Calculating Yield Maintenance
The yield maintenance premium calculation is:
YM = PV of Remaining Payments on the Mortgage × ( IR − TY )
- YM = Yield maintenance
- PV = Present value
- IR = Interest rate
- TY = Treasury yield
The present value factor is determined using:
1 − ( 1 + r ) ^− n / 12 / r
Where ‘r’ is Treasury yield and ’n’ is the number of months left.
Example Calculation
Assume you have a $60,000 remaining loan balance at 5% over five years (60 months). If the Treasury yield drops to 3% when you decide to prepay:
Step 1: Calculate PV:
PV = [ (1 − (1 + 0.03 )^− 60 / 12) / 0.03 ] x $60,000
—> PV = 4.58 x $60,000 —> PV ≈ $274,782.43
Step 2: Calculate Yield Maintenance:
Yield Maintenance = $274,782.43 x (0.05 – 0.03)
Yield Maintenance ≈ $5,495.65
The borrower thus pays an additional $5,495.65 in prepayment fees.
If Treasury yields surge since loan inception, lenders can profit from early repayment by re-investing at higher rates, though prepayment penalties may still apply.
By comprehending and applying yield maintenance, investors and financial institutions can secure expected returns despite interest rate fluctuations and the risk of early loan repayments.
Related Terms: prepayment penalty, interest rate differential, prepayment risk, Treasury yield.
