Yield maintenance, defeasance or step-down: what leaving early costs

How each one is built

Yield maintenance pays the lender the present value of the interest it loses by being repaid early and reinvesting at Treasury yields. If Treasury yields are below your note rate, the premium is large. If they are above it, the formula goes to zero and a minimum applies: a minimum premium of 1% of the balance² at Fannie Mae. CMBS loans with yield maintenance use the same idea: Greater of 1% of the amount prepaid or yield maintenance³.

Defeasance does not repay the loan. You buy a portfolio of Treasuries (or similar securities) whose payments match every remaining payment on the loan, and the securities replace the property as collateral. Defeasance collateral must be non-callable government securities³. An independent CPA must certify the securities cover every scheduled payment³. The cost is the price of those securities, minus your balance, plus fees.

Step-down is a schedule in the note: a percent of the balance in each loan year. Fannie Mae’s 10-year schedule is 10-year fixed: 5-5-4-4-3-3-2-2-1-1, no lockout. Banks write their own, often shorter.

Worked example: one loan, three structures, three rate paths

Illustration. An $8,000,000 interest-only loan carries a 6.10% fixed rate for 10 years. The owner pays it off at the end of year three. Yield maintenance runs through month 114, so 78 months remain; the defeasance securities must cover 81 monthly payments plus the balance at the start of the open period. The step-down follows Fannie’s 10-year schedule, 4% in year four.

Treasury yield at payoff	Yield maintenance (Fannie formula, 1% floor)	Defeasance (securities cost above balance, before fees)	Step-down
4.00% (rates fell)	about $945,000	about $992,000	$320,000
5.00% (rates near today’s)	about $478,000	about $503,000	$320,000
6.50% (rates rose)	$80,000 (the 1% floor)	about $174,000 below the balance	$320,000

Read across each row. When rates fall, both rate-linked structures cost roughly three times the step-down. When rates rise above the note, yield maintenance drops to its floor and defeasance can cost less than the balance, before fees. The step-down is the only one you can budget today.

Defeasance runs slightly above yield maintenance in this example because it replicates three extra months of payments and discounts at the securities’ yield. Then add the fees for the consultant, counsel, accountant and servicer. The borrower pays rating agency fees and the other expenses of defeasance³.

What the lender prefers and why

A lender that sells the loan into a bond pool needs the bondholders’ cash flow protected, so CMBS uses lockout and defeasance and the agencies use yield maintenance. A bank keeping the loan on its own books can live with a step-down, because it can relend the money and values the relationship. That is why a step-down usually comes with a guarantee and a shorter term, and yield maintenance with non-recourse and a longer one.

Where each structure wins

Your situation	Best structure	Why
Likely sale within five years	Step-down	Known cost, no rate risk
Long hold, rates may rise	Yield maintenance	Cost falls to the floor if rates rise
Long hold, buyer will assume the loan	Defeasance	You may never pay it
Loan made when rates were much lower	Any; check the floor	Rate-linked premiums are small today
Refinance at the end of the term	Any	Close inside the open period and pay nothing

Other premiums you will meet

• Fannie Mae SARM and Hybrid ARM. SARM: locked out in loan year 1, then 4%, 3%, 2%, 1%, then 1% in later years where the term runs longer⁵.
• Fannie Mae defeasance option. Where offered, Fannie charges 1% of the scheduled balance at the Defeasance Close Date⁶.
• Freddie Mac fixed-rate. Yield maintenance until securitized, then 2-year lockout and defeasance; open final 90 days⁷.
• SBA 7(a). Applies to 7(a) loans of 15 years or more when voluntary prepayments exceed 25% of the highest balance in any of the first three 12-month periods⁸. The fees: 5% of prepayments in the first 12 months after first disbursement, 3% in the second, 1% in the third⁸.
• HUD 223(f). Prepayment generally prohibited for 5 years from endorsement⁹.

The costs people miss

• The 1% floor. Rising rates do not make yield maintenance free.
• Notice periods. Fannie Mae defeasance: Defeasance closes 30 to 45 calendar days after the servicer receives the notice⁶. Miss the window and the sale closes late.
• Lockouts. No amount of money prepays a locked-out loan. Confirm the lockout end date in months.
• Assumption fees. Often the cheapest CMBS exit, but they cost a fee and a credit review of the buyer.
• Swap breakage. A swapped bank fixed rate carries its own unwind cost on top of any step-down.

Estimate yours with the prepayment penalty calculator, or send the note’s prepayment section and we will price your options to sell or refinance.