What is a yield-maintenance prepayment penalty and how is it calculated?

Yield Maintenance is a prepayment penalty that, in the event the borrower pays off a loan before maturity, allows the lender to attain the same yield as if the borrower had made all scheduled mortgage payments until maturity. Yield maintenance premiums are designed to make lenders indifferent to an early prepayment by a borrower. On the flip side, it can mean that if a borrower currently has a 9.5% rate on its mortgage with 5 or 6 years to go until maturity, at this time the penalty could well be huge.

For example, let's assume a 15-year interest-only $1,000,000 mortgage at 7%. After the 5th year the borrower decides to refinance. The yield maintenance prepayment penalty would equal the difference between the current 7% rate and the yield that the bank would receive reinvesting the loan proceeds in a 10 year Treasury Note. (10 years being the remaining term of the loan).

To keep this example simple, let's say that at the time of prepayment, the 10 year Treasury note is 5%. 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, or $200,000. This penalty will make the lender "whole" and insure that the lender will not experience an economic loss as a result of being paid prior to the loan's maturity. This same formula applies to amortizing loans, however it is much easier to illustrate with an interest-only loan.

Each lender will have a slight variation to this formula, however the above example conveys the spirit of the yield maintenance penalty.