Yield maintenance

Yield maintenance also known as make hole charge[1], is a penalty for prepayment, in which case the borrower repays the loan before maturity, the lender can achieve the same profitability, as if the borrower has made all scheduled mortgage payments to maturity[2].

Definition

The formula is the difference between the loan rate and the rate at which the price would have been measured was on the market, taking into account the remaining period. Another way of looking at this is that it is the current value of the remaining loan payments multiplied by the difference between the interest rate on the loan and the tax rate at the same time[3].

Model

The yield maintenance usually is related to some percentage of the interest to be paid or to value of e.g. treasury notes. Therefore, there is no one formula for calculating yield maintenance penalty. An example formula can be:

YM = PV * (IR - TY)

where:

• YM - yield maintenance
• PV - present value of remaining payments
• IR - interest rate
• TY - treasury yield

The present value is calculated using discount ratio based on treasury yield.

Types of prepayment penalties

also known as "payment" in the industry, is a contract between the borrower and the bank or mortgage lender, which regulates what the borrower can pay back and when. In addition to yield maintenance, here are two other types[4][5]:

• Step-Down, is a kind of prepayment penalty gradually decreasing during the loan period. A typical ten-year term may have a prepayment penalty following: 5-5-4-3-2-1-1-0-0-0. In this simple example, we see that in the first two years of the loan amount to the borrower's penalty five percent of the existing loan balances. If the borrower wants to avoid the cost of early repayment, he must wait until the year 7 of its duration.
Fig. 1 Prepayment penalties: Step-Down
• Defeasance is an alternative to the formula of maintaining profitability, which can bring benefits to the borrower. Although there are some administrative costs, including a possible additional fee for prepayment, in total the potential profit significantly exceeds these costs.

Comparison of yield maintenance and defeasance

Speaking of prepayment methods, they are basically identical in terms of loan repayment, however with different methods[6]. Both called a quick exit startegy. Though the two servethe exact same purpose, they are fundamentally different.

In the case of yield maintenance, the borrower must repay[7]:

• loan's unpaid principal balance,
• prepayment penalty.

Whereas defeasance is determined by[8]:

• price of the bond portfolio, which are sufficient to cover the remaining loan payments
• transaction fees(third parties).

Examples of Yield maintenance

• Yield maintenance is a prepayment penalty payment which is calculated to help the lender recover the lost interest due to the borrower's early repayment of the loan. When a borrower pays off their loan earlier than the agreed upon term, the borrower pays the lender a fee to compensate them for the lost interest. The amount of the fee is based on the size of the loan, the length of the loan, and the interest rate at the time of the prepayment.
• For example, a borrower has a loan of \$100,000 with a 5% interest rate for 5 years. If the borrower decides to pay off the loan after 3 years, the yield maintenance fee would be based on the amount of interest that the lender would have earned over the remaining 2 years.
• Another example is when a borrower has a loan of \$500,000 with a 10% interest rate for 10 years. If the borrower decides to pay off the loan after 5 years, the yield maintenance fee would be based on the amount of interest that the lender would have earned over the remaining 5 years.

Yield maintenance, also known as make hole charge, is a method of prepayment penalty that lenders use to mitigate their losses when a loan is prepaid early. There are several advantages to using yield maintenance:

• It eliminates the need for the lender to spend time and resources to find a new borrower, as the lender is guaranteed to receive their expected yield.
• It can be used to protect the lender from falling interest rates that could reduce the value of the loan after it is prepaid.
• It is predictable and simple to calculate, as the formula is already known and is not subject to changes in market conditions.
• It is generally more cost-effective than other forms of prepayment penalties, as it is based on a fixed rate.
• It helps to ensure that lenders receive the same return on their loan regardless of the market conditions.

Limitations of Yield maintenance

Yield maintenance, also known as make-hole charge, is a penalty applied to borrowers who pay off their loan early. It is designed to ensure that the lender receives the expected return on the loan. While yield maintenance can help protect the lender's interests, it can also impose certain limitations on the borrower. The following list outlines some of these limitations:

• Yield maintenance can be costly. The penalty is usually expressed as a percentage of the loan balance and can be up to several points. This can make it difficult for borrowers to pay off their loan early without incurring significant costs.
• Yield maintenance can be restrictive. Borrowers may be prohibited from refinancing, selling the property, or transferring the loan to another party without the lender's consent. This can limit the borrower's ability to make changes to the loan or access capital.
• Yield maintenance can be difficult to understand. The penalty is often calculated using complex formulas, which may be difficult for borrowers to understand and calculate. This can leave borrowers in a difficult position when trying to determine the cost of prepaying the loan.

Other approaches related to Yield maintenance

Yield maintenance is a prepayment penalty that a borrower pays in order to get out of a loan agreement. There are several other approaches related to yield maintenance that aim to protect lenders in the case of borrower default or prepayment. These include the following:

• Yield maintenance premium (YMP): A fee charged by the lender to cover the difference in expected yield due to the prepayment of the loan. The YMP is calculated as a percentage of the remaining principal balance.
• Interest rate buydown: The borrower pays a fee in order to reduce the interest rate on the loan. This is beneficial to the borrower as it reduces the cost of the loan, but it also reduces the expected yield of the loan.
• Step-up prepayment: This requires the borrower to pay an additional fee if they wish to prepay the loan. This fee is generally in the form of a percentage of the remaining principal balance.
• Defeasance: This is a process where the borrower obtains a new loan and uses the proceeds to pay off the existing loan. This process is generally used when the borrower cannot afford the YMP or other prepayment penalties.

Overall, yield maintenance is a tool used by lenders to protect their interests in the case of borrower default or prepayment. Other approaches such as yield maintenance premiums, interest rate buydowns, step-up prepayments and defeasance can also be used to help protect lenders from losses due to prepayment.

Footnotes

1. Fabozzi J. F., Dunlevy J. N., 2001, p.132
2. Fabozzi J. F., 2001, p.414
3. Fabozzi J. F., Dunlevy J. N., 2001, p.132
4. Marshall D., 2018, ch.12
5. Burke D. B.,2006, p.246
6. Burke D. B.,2006, p.246
7. Fabozzi J. F., 2001, p.414
8. Moulin S., 2017, p.149

 Yield maintenance — recommended articles Short rate cancellation — Effective rent — Implicit interest rate — Reversionary bonus — Life Cap — Adjustable Life Insurance — Swap Ratio — Incremental borrowing rate — Automatic Premium Loan

References

Author: Agnieszka Katarzyna Sikora

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