Yield Maintenance

What it is:

Yield maintenance is a kind of prepayment fee that borrowers pay to banks to reimburse them for the loss of interest resulting from the prepayment of a loan

How it works/Example:

The formula for the yield maintenance premium is:

Yield Maintenance = Present Value of Remaining Payments on the Mortgage x (Interest Rate - Treasury Rate)

Note that the Treasury rate should be for bonds of the same duration as the mortgage in question.

Let's assume John takes out a $1,000,000 mortgage from ABC Bank at 7%. The borrower begins making monthly payments on the mortgage. Two years later, interest rates decline dramatically, and John chooses to refinance the loan. To do so, John repays the $1,000,000 loan by taking out a similar loan at a lower interest rate from a different lender and paying off the first loan. As a result, ABC Bank loses eight years of interest payments that it would have otherwise gotten had interest rates not declined enough to induce the borrower to go elsewhere.

The bank calculates yield maintenance based on current interest rates and projected rates over the course of the life of the mortgage.

Why it Matters:

Yield maintenance helps lenders make the same yield regardless of whether all the mortgage payments are made until maturity. The idea behind yield maintenance is that it enables lenders to be indifferent to prepayment. Yield maintenance is most common in the commercial mortgage industry.

Best execution refers to the imperative that a broker, market maker, or other agent acting on behalf of an investor is obligated to execute the investor's order in a way that is most advantageous to the investor rather than the agent.