Yield maintenance and defeasance

How it works

Both exist because a fixed-rate lender priced the loan expecting to receive interest for its full term. If rates have fallen since origination, early repayment forces reinvestment at a lower yield, and these provisions transfer that loss back to the borrower. When rates have risen, yield maintenance often costs little or nothing beyond a minimum, typically one percent, while defeasance can in principle produce a small credit because the securities cost less than the remaining balance.

The mechanics differ in a way that matters for planning. Yield maintenance is a calculation and a payment, so it can be estimated in advance from the remaining payment schedule and the current Treasury curve. Defeasance is a transaction: a securities portfolio is purchased to replicate the remaining debt service, the loan is assigned to a successor borrower, and accountants, attorneys, a rating agency and a defeasance consultant all have to be paid. Transaction costs commonly run into six figures and the process takes weeks.

The practical consequence is that prepayment terms constrain the business plan, not just the debt cost. A five-year fixed loan with four years of yield maintenance on a value-add deal quietly rules out the early sale that the value-add thesis is designed to produce. That should be priced when the loan is selected, not discovered when the offer arrives.

Worked example

Conventions worth knowing

• Open prepayment windows in the final months before maturity are common and are usually the cheapest exit. Check the date.
• Assumability can be worth more than a rate discount. A below-market assumable loan is a real asset to a future buyer and can be marketed as one.

The common mistake