What is Yield Maintenance and Why Should You Care?
Yield maintenance is a type of prepayment penalty designed to keep investors happy. If you've invested money expecting to earn a certain amount over a period, and the borrower pays it all back early, you'd miss out on those expected interest earnings. Yield maintenance ensures that if a borrower prepays their mortgage, the lender still receives an equivalent yield.
If you're a borrower, you need to be aware of this penalty to avoid unexpected costs. If you're an investor, this ensures your earnings are protected.
How to Calculate Yield Maintenance
Here's the main formula:
[\text{YM} = \text{Present Value of Remaining Payments} \times \left(\frac{\text{Interest Rate}}{100} - \frac{\text{Treasury Yield}}{100}\right)]
Where:
- YM is the Yield Maintenance penalty
- Present Value of Remaining Payments is the current value of all future mortgage payments
- Interest Rate is your loan's interest rate (percentage)
- Treasury Yield is the current treasury yield (percentage)
Calculating Present Value
Before calculating yield maintenance, you need the present value of remaining payments:
[\text{Present Value} = \left(\frac{1 - (1 + r)^{-n}}{r}\right) \times B]
Where:
- r is the monthly interest rate
- n is the number of months remaining
- B is the loan balance
Calculation Example
Suppose you have a mortgage with:
- Balance: $300,000
- Annual interest rate: 5%
- 20 years (240 months) remaining
- Current treasury yield: 3%
Step 1: Calculate Present Value
First, convert the annual interest rate to a monthly rate:
[\text{Monthly Rate} = \frac{5}{12} = 0.004167]
For this example, the present value approximates $300,000.
Step 2: Calculate Yield Maintenance
[\text{YM} = 300{,}000 \times \left(0.05 - 0.03\right)]
[\text{YM} = 300{,}000 \times 0.02 = 6{,}000]
Your yield maintenance penalty would be $6,000.