What is yield maintenance?

By allowing investors to receive the same return as if the borrower had paid all of the planned interest payments up to the maturity date, yield maintenance functions as a prepayment penalty. The time left before loan maturity requires borrowers to pay the difference between the loan interest rate and the going market interest rate on the prepaid capital.

The purpose of yield maintenance premiums is to numb investors’ feelings toward prepayment, settling a debt, or installment loans ahead of schedule. Additionally, it renders refinancing unfavorable and unfeasible for debtors.

Understanding Yield Maintenance

The lender gets compensated with interest regularly for using their funds when a borrower receives financing, whether via bond issuance or a loan (such as a mortgage, vehicle loan, business loan, etc.). For the lender, who predicts profits based on the rate, the expected interest is a rate of return.

For instance, an investor purchasing a $100,000 face-value 10-year bond with a 7% annual coupon rate expects to get a yearly credit of 7% x $100,000 = $7,000. Similarly, until the borrower pays off the mortgage years later, the bank that authorizes a $350,000 loan at a fixed interest rate anticipates receiving monthly interest payments.

Nonetheless, there are instances when the borrower calls in a bond or pays off the debt ahead of schedule. Prepayment risk refers to the possibility of an early principal return; in finance, “prepayment” is the settlement of a debt or installment loan before the loan’s formal due date. It is present in every loan instrument, and lenders must deal with it to some extent. There’s a chance the lender will get the interest revenue stream in less time than anticipated.

The most frequent cause of loan prepayment is an interest rate decline, which gives the borrower or bond issuer the chance to refinance their debt at a more affordable rate.

A prepayment fee or premium, sometimes called yield maintenance, is assessed to reimburse lenders in the unlikely event that a borrower repays the loan sooner than expected. Essentially, yield maintenance protects the lender against loss by allowing it to collect its initial yield.

The commercial mortgage sector is the one where yield maintenance is most prevalent. For illustration purposes, consider a building owner who has taken out a loan to purchase a nearby property. After five years, the owner wishes to refinance since interest rates have significantly dropped on the 30-year mortgage. He takes out a loan from another lender to pay off his previous mortgage. The bank that issued the mortgage would be able to reinvest the money that was returned to them along with the penalty amount in safe Treasury securities and receive the same cash flow as they would have if they had received all of the scheduled loan payments for the whole loan term, even if the bank charged a yield maintenance fee or premium.

How Yield Maintenance Is Calculated

The yield maintenance premium may be computed using the following formula:

YM=RP’s PV on the Mortgage×(IR-TY) in which

Yield maintenance is YM.

PV=Value at present

RP = Balance of payments

Interest Rate (IR)

The Treasury yield is TY.

The formula’s present value component may be computed as follows: r 1−(1+r)− 12 n

Treasury yield = r.

n=Monthly total

For illustration purposes, assume that a borrower has a $60,000 loan debt with 5% interest. There are precisely five years or sixty months left on the debt. If the borrower chooses to repay the loan when the 5-year Treasury note interest falls to 3%, this method may be used to compute the yield maintenance.

Step 1: PV = [(1 – (1.03)^-60/12)/0.03] x $60,000

PV = 4.58 x $60,000

PV = $274,782.43

Step 2: Yield Maintenance = $274,782.43 x (0.05-0.03)

Yield Maintenance = $274,782.43 x (0.05 – 0.03)

Yield Maintenance = $5,495.65

An extra $5,495.65 will be required from the borrower to repay his loan.

The lender may benefit by taking the early loan payback amount and lending the money out at a higher rate or by investing the money in better-paying government bonds if government rates rise from where they were when the loan was taken out. The lender will nonetheless be assessed a prepayment penalty on the principal amount, even if there is no yield loss.

Conclusion

• A prepayment charge known as yield maintenance is paid by bond issuers to investors or by borrowers to lenders to make up for the interest lost when a bond is called in or a loan is prepaid.
• The goal of yield maintenance is to deter borrowers from paying off their obligations early to reduce the risk of prepayment to lenders.
• Yield Maintenance = Present Value of Remaining Mortgage Payments x (Interest Rate minus Treasury Yield) is the formula to compute a yield maintenance premium.