December 6, 2017
By Terry Painter, Mortgage Banker
Member of the Forbes Real Estate Council
What is Yield Maintenance? Why is it so difficult to get a straight answer on this?
So imagine you are taking out a commercial loan and you’re told that the prepayment penalty is yield maintenance. No one—and I mean not even the lender—can likely give you an explanation that gives you that feeling of comfort where you finally say to yourself, “Ok, I get it”.
Yield Maintenance Definition
Fundamentally, yield maintenance is a form of prepayment penalty. It is a mathematical calculation, or equation, which tells the lender, at the time you want to prepay your loan, what the loss will be by allowing you to prepay early. In essence, Yield Maintenance guarantees that if the borrower prepays the loan early, the lender will make the same yield (amount of interest earned) as though the borrower made all the payments due the lender during the term of the loan. If treasury yields go down from where they were when you took out your loan the lender will realize a loss if you prepay early and will pass that loss on to you. This can result in a prohibitive prepayment penalty that that can be a financial burden to you. If treasury yields go up from where they were when you took out the loan the lender can actually make a profit by investing the money in higher paying treasury bonds. In this case there is no yield loss to the lender but they will still charge you a prepayment penalty of 1.00% of the principal balance. This is an amount you likely can afford. Therefore, if rates go up significantly when you want to prepay your loan early, yield maintenance can be a more optimum form of prepayment penalty for you.
Is Yield Maintanace a Fair Prepayment Penalty?
Is yield maintenance fair? Commercial mortgage loans that have yield maintenance prepayment penalties have some of the lowest mortgage rates and are almost always lower than similar loan programs with declining prepayment penalties. You are benefiting with these low rates (on average a half point lower or more), but also taking a risk that if rates go down in the future (and you want to prepay early) that it will cost you an arm and leg to prepay the loan early. Look at it from the lender’s point of view. After all, you did agree to take out the loan for the full term. The lender is giving you a lower rate in exchange for guaranteeing him/her that they will be able to realize the loan earnings for the full fixed rate term of the loan. In many cases, the lender has sold your loan on the secondary market—perhaps to Fannie Mae or Freddie Mac. Your loan is bundled or pooled with other loans with the same maturity and sold as a mortgage-backed security bond on Wall Street. The investors who buy these bonds are promised a rate of return based on your interest rate for the full term minus 90 days of your loan term. The holder of these bonds is not going to take a loss if your prepayment of the loan creates a loss to the investors. He will pass this loss onto your lender who will pass it on to you. The yield maintenance calculation guarantees that the lender (or those he sold the loan to) will be made whole should rates go down lower than when you took out your loan thus resulting in a lower yield.
How is Yield Maintenance Calculated?
In calculating the yield maintenance prepayment penalty, the following factors need to be known:
- Original loan amount
- Original interest rate
- Today’s interest rate on the same loan program
- Amortization on your current loan
- Date of your first loan payment on your current loan
- Maturity Date of your current loan less 90 days
- Date you intend to prepay the loan
Here is a simplified example: Let us say that your commercial loan has a 10 year term. After 7 years, you decide to sell the property. When you took out your loan, the 10 year treasury bond had a yield of 4.00%. Now, that 10 year treasury bond has a yield of 3.00%. With a yield maintenance prepayment penalty you will have to pay a penalty of 1.00% times the principal balance, times the remaining term of your loan. This amount will equal what the lender will lose by investing the principal balance in today’s 10 year treasury bond earnings of 3.00%. As mentioned, if treasury yields have gone up since you took out your loan the lender can invest the payoff in treasury bonds where he will actualize a profit and your yield maintenance prepayment penalty will be 1.00%.
For a more mathematical explanation (greatly simplified)
If rates have gone down since you took out the loan and you want to prepay early, take the interest rate on your loan and subtract it from the rate today on the same loan program and multiply this by the principal balance. Take that number and calculate the daily interest lost by early prepayment. Then take this number times the remaining days left in your loan term and that will be your yield maintenance prepayment penalty:
— New Rate
Principal Balance X Difference X # of days until current loan matures = YM
Questions and Answers
Question: Should I worry about having a loan with yield maintenance? Is a loan with yield maintenance the right choice for me?
Answer: You do not need to worry about yield maintenance if you know you are going to keep the loan for the full loan term and are not planning on selling the property or refinancing the loan during this period. Also, if rates are unusually low now and not likely to go lower in the future. In both of these cases, you will benefit from the lower rates that loans with yield maintenance offer. If, unexpectedly, you do need to prepay your loan early—as long as rates have gone up significantly—you will just have a 1.00% prepayment penalty, which you can likely afford. In both of these cases, yield maintenance is likely the best prepayment penalty for you.
If you think it is likely that you will sell the property before the loan term is up and/or you think rates might go down lower than the current rates, yield maintenance is not the best prepayment penalty for you.
Question: You would like to take advantage of a 10 year fixed mortgage and have found a multifamily loan program that has the lowest rates but also has the yield maintenance prepayment penalty. You are concerned that you might want take some cash out of the property in the future and if rates go the wrong direction you will not be able to refinance the property because the yield maintenance prepayment penalty will be too high.
Answer: The best solution for you is to choose a Fannie Mae or Freddie Mac loan. Both of these loan programs will offer you a supplemental loan in second position after the first 12 months at up to 75% of appraised value. If you wait two—four years to apply for this option and you have raised your rents, most likely the value of your property will have gone up significantly – thus, your equity in the property will have gone up and you can put a second on it to take cash out.
Question: I would like to prepay my current commercial mortgage early and it has a yield maintenance prepayment penalty. How do I determine what the prepayment penalty is today?
Answer: Although you can use a yield maintenance calculator, to get an estimated pay off, it is best to call the lender or the servicer of your current loan and request a payoff. They will put this into their computer and will be able to tell you the exact yield maintenance prepayment penalty. This might take several weeks. If you need this right away let them know.
Yield maintenance can be a good way to go in certain commercial loan situations. However, get some basic understanding of yield maintenance and meld it with your current investment goals to be sure it’s a good choice for you. Call one of our friendly loan specialists to discuss your financing needs, your future goals and strategies to determine the right loan program for you: 503-376-7303