How these options work
When a commercial mortgage is paid off before maturity, lenders lose the interest they expected to collect. Yield maintenance and defeasance are two contractual responses that protect that expected return.
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Yield maintenance: The borrower pays a cash amount designed to make the lender economically whole for the difference between the loan’s scheduled interest and what the lender can earn by reinvesting the prepaid principal at current market rates. Lenders typically calculate this fee using the remaining scheduled payments discounted at a Treasury yield plus a spread (check your loan note for the exact formula).
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Defeasance: Instead of a cash prepayment fee, the borrower (or a defeasance provider acting for the borrower) buys U.S. Treasury securities or agencies and structures them so their coupon and principal payments match the loan’s remaining payment schedule. The securities become the lender’s collateral; the borrower is released from the mortgage but the loan remains in place until the securities extinguish the payments. For more on Treasury instruments used in defeasance, see TreasuryDirect (treasurydirect.gov).
(Consumer Financial Protection Bureau explains how prepayment penalties can affect borrowers: https://www.consumerfinance.gov/.)
Why this matters for refinancing or sale
Both options aim to avoid renegotiating loan economics. The practical differences that drive borrower choices are:
- Cash needed upfront: Yield maintenance usually requires a single lump-sum cash payment; defeasance requires capital to buy and structure securities (and pays fees to a defeasance trustee/agent).
- Liquidity and operations: Defeasance preserves borrower cash flow because cash from the sale of the property can be retained while securities service the loan; yield maintenance reduces borrower liquidity by the prepayment outflow.
- Complexity and cost structure: Defeasance involves more legal, trustee, and execution steps; yield maintenance is often simpler to calculate and implement.
Real-world example (illustrative)
A borrower has a $5 million fixed-rate loan at 5% with 7 years remaining. Current Treasury yields for comparable maturities are 2.5%. Under yield maintenance, the lender calculates the net present value of the difference between the contract rate and reinvestment rate and bills the borrower the present value of the lost spread—often several percent of outstanding principal depending on timing and curves. Under defeasance, the borrower would purchase Treasury securities sized to cover the same remaining payment stream; transaction and trustee fees apply, but the borrower can free the property from the mortgage.
Who typically uses each option
- Yield maintenance is common for fixed-rate commercial loans and is often embedded as a clause for loans with long-term, stable interest economics. See our guide on What a Yield Maintenance Clause Means for Borrowers.
- Defeasance is frequently used when borrowers want to sell or refinance but the loan documents prohibit cash prepayment or when defeasance is contractually allowed. See the related Defeasance Clause glossary entry for contract issues and process.
Pros and cons — quick comparison
| Feature | Yield Maintenance | Defeasance |
|---|---|---|
| Upfront cash required | Typically a lump-sum prepayment | Capital to buy securities + fees |
| Effect on cash flow | Reduces borrower liquidity | Preserves borrower sale proceeds/cash flow |
| Complexity | Lower | Higher (trustee, securities, legal) |
| Timing | Often faster | Takes longer to execute |
Practical selection checklist
- Read the loan documents: Confirm whether the note allows defeasance and the exact yield maintenance formula. Our article on Key Clauses in Commercial Loan Agreements helps identify relevant language.
- Get quotes: Ask your lender for a yield maintenance payoff figure and obtain defeasance pricing from a qualified provider.
- Run a cash-flow breakeven: Compare net cost (fees, transaction costs, lost liquidity) to the benefits of the new financing or sale proceeds.
- Factor timing: If you need a quick payoff, yield maintenance may close faster; defeasance requires coordination with a securities provider and trustee.
- Consult specialists: Use a commercial mortgage attorney and a defeasance consultant when the tradeoffs are material.
Common mistakes to avoid
- Assuming one option is always cheaper—cost depends on rates, timing, and transaction fees.
- Overlooking tax or accounting consequences—work with your CPA to confirm treatment (IRS guidance and tax treatment vary by circumstance).
- Ignoring loan-specific clauses that limit or condition defeasance; always confirm mechanics in the note and mortgage.
Professional tips
- If interest rates have fallen substantially since origination, yield maintenance charges can be large; defeasance may be more attractive if you can preserve sale proceeds.
- For smaller loan balances the fixed costs of defeasance (trustee, legal, structuring) can make yield maintenance the simpler choice.
- Negotiate: When originating or refinancing, ask lenders for flexibility on prepayment terms or built-in waivers tied to sale or refinance triggers.
Sources and next steps
This entry is educational and does not replace personalized advice. Consult your lender, CPA, and counsel before choosing a path.
Authoritative resources:
- Consumer Financial Protection Bureau — prepayment penalty and borrower protections: https://www.consumerfinance.gov/
- U.S. Department of the Treasury / TreasuryDirect — Treasury securities used in defeasance: https://www.treasurydirect.gov/
For related guidance on avoiding prepayment penalties and planning an exit strategy, see our posts on Strategies to Avoid Prepayment Penalties on Commercial Loans and Planning for Loan Maturity: Preparing a Refinance or Exit Strategy.
Professional disclaimer: This information is educational and general in nature. It is not legal, tax, or investment advice. Consult licensed professionals for recommendations tailored to your situation.
