If you are looking to finance an investment in multifamily or commercial real estate, a term you may hear getting thrown around is “yield maintenance.” This term refers to a fee that the lender of a loan may charge to discourage the borrower from paying off the mortgage loan early. So why does this matter? Let’s take a look.
Say you are a commercial real estate investor (maybe some of you already are). You want to purchase a new property so you take out a 30-year mortgage at a given interest rate to make this happen. A few years later, interest rates fall significantly below the original interest rate you pay on your mortgage. You’re a financially conscious person looking to save money, so you decide to refinance.
You go to another lender and get a loan at a lower interest rate for the remaining amount owed on your original 30-year mortgage. You can pay off your original mortgage and pay less interest over time on your new mortgage. Easy money, right? Not so fast! The bank you originally borrowed from may impose a “yield maintenance” fee for an early “prepayment” of your original mortgage that will make you think twice about refinancing for a lower interest rate.
As a reminder of how interest typically plays into mortgages, take this example. A bank approves a house loan (mortgage) for $600,000 over 15 years at a fixed monthly interest rate of 5%. With this monthly interest rate, the bank expects the borrower to make monthly payments toward the original $600,000 borrowed, as well as 5% every month of the remaining balance on their loan. If the market interest rates on mortgages goes down (we’ll see if that actually happens any time soon) in this example below 5%, it will be in the borrower’s best interest (see what we did there) to take out another loan to pay off their original mortgage.
This process is called refinancing. The borrower will still have to pay off the new loan, but they will now be paying less than 5% in interest monthly. A drop in interest rates is primarily what makes refinancing attractive to borrowers. Yield maintenance is designed to keep borrowers from happy-go-lucky refinancing at the expense of lenders.
On a loan without yield maintenance, if the borrower pays off their loan early, the lender will lose the revenue from the remaining interest payments that were scheduled over the life of the loan. Yield maintenance is a fee charged to borrowers for early “prepayment” of loans, designed to discourage borrowers from refinancing. Should a borrower refinance, yield maintenance allows the lender to recoup any lost revenue from forgone interest payments.
So how exactly does yield maintenance do this? A borrower wants to pay off a loan with a yield maintenance penalty early. To do this, they not only have to pay the principal loan amount back, but the yield maintenance fee as well. The lender can take the returned loan amount, along with the fee, and reinvest the money into treasury securities. These treasury securities are bonds which can give the same or better rate of return as the interest on the original loan.
The treasury yields (rate of return) may be higher at the time of prepayment than when the loan was originally issued. If this is the case, the lender can profit from reinvesting the prepayment and the yield maintenance fee into treasury securities. Also, if market interest rates are higher than the interest rate on the original loan, the lender can profit by lending out the returned money at a higher interest rate.
Yield maintenance is typically calculated using the following formula: Present Value of Remaining Payments on a Loan * (Market Interest Rate - Treasury Yield). Let’s break this down.
- Present Value of Remaining Payments on a Loan: At a given time, the amount of money owed (principal + interest) on a loan.
- Market Interest Rate: The “prevailing” percentage in a market being charged to borrow money.
- Treasury Yield: The rate of return from investing in US Treasury bonds.
This formula set determines the yield maintenance fee amount such that the lender can recoup or even profit from interest lost in prepayment. It does this by multiplying the present value of the remaining loan by not just the market interest rate, but the market interest rate minus the rate of return on treasury securities. The treasury yield is subtracted from the market interest rate because the treasury yield will make up for a portion of the lost revenue from forgone interest payments.
Conclusion
As someone considering a loan for real estate with yield maintenance, consider both the advantages and disadvantages. One of the benefits of securing a mortgage with a yield maintenance penalty is that lenders are more likely to offer you a lower interest rate because their risk of loss is much lower. Additionally, closing fees on mortgages with yield maintenance are generally lower than if not.
As discussed above, the biggest disadvantage of a mortgage with yield maintenance is that it can make refinancing cost prohibitive. If you anticipate paying off a loan early, then you will want to be cautious about loans with a yield maintenance premium. If you are locked into a loan with a yield maintenance premium, keep in mind the differential between the yield maintenance payment and the advantages of refinancing a loan at a lower interest rate. Even if you are able to refinance to a loan at a lower interest rate, the yield maintenance premium may cancel out the money to be saved on interest payments.
As a real estate investor, you’ll want to weigh different financing options with their benefits and penalties to make the wisest, most profitable investment decision.
