Yield maintenance charges the borrower what the lender loses by being repaid early: roughly the present value of the gap between the loan's rate and the Treasury yield over the remaining protected term. It is expensive when rates have fallen and much term remains. Defeasance reaches a similar cost by substituting Treasuries as collateral. A step-down penalty is a fixed, falling percentage of the balance, such as 5-4-3-2-1 over five years, and ignores rates. SBA 7(a) loans of 15 years or more carry SBA's own fee in the first three years only. If a sale or refinance is likely, these differences can outweigh a quarter-point of rate.
- Yield maintenance
- Lender's lost interest, discounted; large when rates fall, near a minimum when they rise
- Defeasance
- Borrower buys Treasuries to replace the loan's payments; similar economics, plus third-party costs
- Step-down
- A set share of the balance that falls each year, for example 5-4-3-2-1; ignores rates
- SBA 7(a), 15 years or more
- Prepaying more than 25% in a year costs 5%, 3% and 1% in years one to three; nothing after
- What to compare
- The exit cost in the year you expect to sell or refinance, against the rate saving
Why lenders charge to be repaid early
A lender that makes a fixed-rate loan has either funded it with fixed-rate money or hedged it. If the borrower repays early after rates have fallen, the lender gets its principal back and can only reinvest it at the lower rate. A prepayment penalty is the lender's protection against that loss, and on some loans it is also compensation for the cost of putting the loan on the books. The structure of the penalty decides who carries the risk of a rate move: the borrower under yield maintenance, the lender under a step-down.
Floating-rate loans usually carry lighter penalties or none, because the lender's income resets with the market. Where a bank has fixed a floating loan with an interest rate swap, the cost of exit sits in the swap instead: breaking it can cost the borrower money when rates have fallen and return money when they have risen. See fixed vs variable rate and swap vs cap.
The four structures
Yield maintenance makes the lender whole for the interest it will not earn. The calculation takes the difference between the loan's rate and the yield on a Treasury of matching remaining term, applies it to the balance for each remaining period of protection, and discounts the result to today. Many agreements also set a minimum premium that applies even when the formula produces nothing. It is common on fixed-rate commercial mortgages from insurance companies and some banks, and in private credit, where the same idea is usually called a make-whole.
Defeasance does not repay the loan at all. The borrower buys a portfolio of Treasury securities whose payments match the loan's remaining payments, the securities replace the property as collateral, and a successor entity takes over the loan. The borrower's cost is the price of those securities over the loan balance, plus fees for the consultant, accountants, lawyers and the loan servicer. It is standard on securitized commercial mortgages. When Treasury yields are above the loan's rate, the securities can cost less than the balance, which yield maintenance's minimum premium never allows.
Step-down penalties are a fixed share of the amount prepaid that declines on a schedule, such as 5 in every 100 prepaid in year one, 4 in year two and so on to 1 in year five, then nothing. Some schedules are shorter, such as 3-2-1. The cost is known on the day the loan closes and does not depend on rates.
SBA's prepayment fee applies only to 7(a) loans with a maturity of 15 years or more, and only when more than 25% of the balance is prepaid in any of the first three years. It is 5% of the prepaid amount in year one, 3% in year two and 1% in year three. After year three, and on any 7(a) loan under 15 years, SBA charges nothing. SBA 504 debentures carry their own premium, which declines over the first half of the debenture's term; the bank's first lien in a 504 has whatever terms the bank set. See the SBA prepayment penalty.
What each costs to exit: a worked example
A business owes 2,000,000 on a seven-year loan and repays it at the end of year two, with five years left, because the owner is selling the company. For simplicity the loan is interest-only. Under yield maintenance, suppose rates have fallen so the loan's rate is 3 points above the matching Treasury yield. The lender loses 3 of every 100 a year, 60,000 a year, for five years; discounted at a Treasury yield of about 4 in every 100, that is about 267,000. If instead rates had risen above the loan's rate, the formula gives nothing and only the agreement's minimum premium applies.
| Structure | Exit at the end of year two, five years left | Exit at the end of year four, three years left |
|---|---|---|
| Yield maintenance, rates fell 3 points | About 267,000 | About 167,000 |
| Yield maintenance, rates rose | The agreement's minimum premium | The agreement's minimum premium |
| Defeasance, rates fell | Similar to yield maintenance, plus third-party costs | Similar to yield maintenance, plus third-party costs |
| Step-down 5-4-3-2-1 | 80,000 (4 in every 100) | 40,000 (2 in every 100) |
| An SBA 7(a) loan of 15 years or more, same balance, fully prepaid | 60,000 (3% in year two) | Nothing |
| Floating-rate loan, no penalty | Nothing | Nothing |
Now compare the rate. On 2,000,000, a quarter of a point of interest is 5,000 a year, or 25,000 over five years. In year two, the gap between yield maintenance after a fall in rates and a step-down is almost 190,000. A borrower who took the yield-maintenance loan to save a quarter-point would have saved about 10,000 of interest by the sale, and handed back far more than that on the way out.
If a sale or refinance is likely, compare offers on what each costs in the year you expect to exit, not only on rate.
Which structure fits which plan
| Your likely path | What to look for |
|---|---|
| Hold the loan to maturity | Rate matters most; yield maintenance costs nothing if you never prepay |
| Sell the business within a few years | A short step-down, an SBA 7(a) under 15 years, or a floating-rate loan; ask whether a buyer can assume the loan |
| Refinance when rates fall | Avoid yield maintenance and defeasance; they are designed to take that saving back |
| Refinance when the business outgrows the lender | A step-down that ends before you expect to move, or a partial-prepayment allowance |
| Pay down early from excess cash | An annual allowance to prepay part of the balance without penalty |
The same thinking applies to call protection on private credit loans, where a non-call period is followed by a declining premium. See call protection and prepayment penalties across loan types.
What can be negotiated
Prepayment terms are set in the term sheet, and they are far easier to change there than after closing. Points worth raising:
- A shorter protected period. Yield maintenance or a step-down that ends years before maturity, with open prepayment afterwards.
- Step-down in place of yield maintenance, accepting a slightly higher rate for a known exit cost.
- Partial prepayment allowances, so paying down from excess cash does not trigger a premium.
- Exceptions for insurance and condemnation proceeds, and for repayment from a sale of the business where the lender will agree.
- Assumption rights, letting a qualified buyer take over the loan instead of repaying it.
- A waiver when refinancing with the same lender, which some lenders grant to keep the relationship.
Before refinancing any loan, work out the exit cost first and set it against the saving; the break-even calculation shows how. When Transparent builds a financing model, the prepayment terms of every offer are modeled at the borrower's likely exit date so that offers are compared on their all-in cost.
Common questions
- Is yield maintenance always more expensive than a step-down?
- No. When rates have risen since the loan closed, yield maintenance often falls to its minimum premium, which can be less than a step-down. It is expensive when rates have fallen and much of the protected term remains, which is exactly when borrowers most want to refinance.
- What does 5-4-3-2-1 mean on a loan?
- It is a step-down prepayment schedule: 5 in every 100 prepaid in year one, 4 in year two, then 3, 2 and 1, with no penalty after year five. The cost depends only on the year and the amount prepaid.
- Does the SBA prepayment penalty apply to every SBA loan?
- No. It applies only to 7(a) loans with a maturity of 15 years or more, and only when more than 25% is prepaid in any of the first three years: 5% in year one, 3% in year two and 1% in year three. After that, and on shorter loans, SBA charges nothing.
- What is the difference between yield maintenance and defeasance?
- Yield maintenance is a cash payment to the lender that ends the loan. Defeasance keeps the loan alive: the borrower buys Treasuries that make its remaining payments, and the loan passes to a successor entity. The economics are similar, but defeasance adds third-party costs and can cost less than the balance when rates have risen.
- If I sell my business, do I still pay the prepayment penalty?
- Usually, yes, unless the loan agreement exempts a sale or a buyer is allowed to assume the loan. A sale repays the loan in full, so the penalty applies to the whole balance.
- Is a lower rate worth accepting yield maintenance?
- Only if you are confident you will hold the loan to the end of its protected period. On a large balance, a quarter-point of rate is small next to what yield maintenance can cost if rates fall and you need to exit early.