What is Yield Maintenance?
Yield maintenance is a kind of prepayment fee that borrowers pay to banks to reimburse them for the loss of interest resulting from the prepayment of a loan.
How Does Yield Maintenance Work?
The formula for the yield maintenance premium is:
Yield Maintenance = Present Value of Remaining Payments on the Mortgage x (Interest Rate - Treasury Rate)
note that the Treasury rate should be for bonds of the same duration as the mortgage in question.
Let's assume John takes out a $1,000,000 mortgage from ABC Bank at 7%. The borrower begins making monthly payments on the mortgage. Two years later, interest rates decline dramatically, and John chooses to refinance the loan. To do so, John repays the $1,000,000 loan by taking out a similar loan at a lower interest rate from a different lender and paying off the first loan. As a result, ABC Bank loses eight years of interest payments that it would have otherwise gotten had interest rates not declined enough to induce the borrower to go elsewhere.
The bank calculates yield maintenance based on current interest rates and projected rates over the course of the life of the mortgage.
Why Does Yield Maintenance Matter?
Yield maintenance helps lenders make the same yield regardless of whether all the mortgage payments are made until maturity. The idea behind yield maintenance is that it enables lenders to be indifferent to prepayment. Yield maintenance is most common in the commercial mortgage industry.
