It has been our experience that Yield Maintenance prepayment penalties have been a difficult notion to grasp by borrowers and mortgage brokers alike. In the current market environment, Yield Maintenance is more prevalent than ever. Therefore, having a good understanding of it can be an invaluable tool when selling a client on a multifamily or commercial mortgage loan. Below is an easy to understand explanation of Yield Maintenance for your reference.
Yield Maintenance: It sounds like a complicated and sometimes scary form of prepayment penalty, generally associated with Multi-family and Commercial real estate loans. It’s actually easier to understand and to calculate than it appears, and in some market environments, it can allow for a much less expensive penalty than the prepayment penalty system that you may be accustomed to.
When you settle into a loan agreement with a lender, that lender has already figured out the amount of money that they want/need to make on that loan, all the way through to maturity. If a loan is paid off prior to maturity, then the lender isn’t necessarily making that desired amount and may even be losing money. The solution for this problem is the prepayment penalty. By potentially paying an additional sum, you will be allowed to pay off the loan early, while the lender still benefits from the original transaction.
With a Yield Maintenance prepayment penalty, the lender will begin by calculating the amount of interest they would have collected beginning on the requested payoff date through the end of the prepayment penalty period. Their next step is to verify the cost of purchasing a US Treasury Bond. If they were to invest the money from the payoff of the loan in a US Treasury Bond, would they be able make the same yield (interest) with the same intended maturity date as they would have if the loan was not prepaid? If the answer is no, then the prepayment penalty will be calculated by multiplying the principal amount being prepaid by the present value of the difference between the remaining yield on the mortgage and the yield of a US Treasury bond, whose maturity date is equal to that of the prepaid loan.
Different factors can affect the amount of the penalty. If the loan is on the latter end of its yield maintenance time frame, then the chances of having a smaller prepayment penalty are greater than if it was in the earlier part of that time frame. This is simply because the amount of interest due through the end of the prepayment period gets shorter as the time frame gets shorter.
Interest rates are also a big factor. In a low rate environment, entering into a loan with a Yield Maintenance prepayment penalty can be a valuable tool. If interest rates rise and the yield on the US treasury bonds rise, then depending on how much interest is left to be paid, your prepayment penalty could be very low or even non-existent. In a high rate environment, the opposite could exist.
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