Question:

What is a yield-maintenance prepayment penalty?

Answer:

Yield maintenance prepayment penalty is a fee that the borrower pays to the lender if he/she pays off the loan before the originally agreed period. The amount of the penalty is calculated to be such that it allows the lenders to achieve the same yield as they would have had if the borrower had continued making scheduled payments.

Yield maintenance penalties are designed to make lenders secure against the risk of an early prepayment by a borrower. The amount can be huge if the prepayment is made early in the lifetime of the loan.

Typical Industry Yield Maintenance Prepayment Penalties:

A typical yield maintenance prepayment penalty is the larger of

  • a minimum penalty, e.g. 1%, or
  • the difference between the yield on the mortgage and the yield on reinvestment.

This reinvestment rate of return is usually the yield on U.S. Treasury Notes with terms equal to the remaining life of the mortgage.  The theory is that the lender replaces the paid-off loan with T-Bills and earns a yield on them.

An Example of Yield Maintenance Prepayment Penalty:

Let us consider a $100,000 mortgage at 6% to be paid in 20 years. After the 4th year the borrower decides to refinance. Now the yield maintenance prepayment penalty would be equal to the difference between the 6% yield and the yield that the bank would receive reinvesting the prepaid money in a 16 year Treasury note (16 year note because that's the mortgage's remaining term).

Suppose at the time of prepayment, the 16 year Treasury note has a yield of 4%. The borrower would be required to pay the lender the present value of the 2% difference for each year over the loan's ten remaining years. The yearly amount would be converted to a present value and that would be the yield maintenance prepayment penalty.

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