What are the Waterfall Payments?
Waterfall Payment is a payment method wherein a high-tier creditor’s interest and principal payments are repaid first after which lower-tier creditors are paid. High tier creditors always have first preference in payment as their investments are expensive. It protects the lenders higher up in the debt structure as their payments are made ahead of their subordinates. These payments are structured to pay off one loan at a time or many loans in a systematic fashion.
Get complete FRM Online Course by experts Click Here
How does it work?
Waterfall payment is used for various loan agreements of different degrees of hierarchy and prioritization. In the case of waterfall payments, multiple loans are separated into tranches and higher loans receive interest and principal before lower loans receive any interest payments. In the payment circle, all levels of loan tranches receive payment, but this is done based on hierarchy.
Let us consider that few buckets are vertically placed and the waterfalls into the bucket. Here the money is represented as water and creditors as a bucket. The water initially falls into the first bucket and after it is filled up the water flows into the second bucket and the process continues till the last bucket is filled.
In the above image, we see that debtor has to fill Creditor A’s bucket till the yellow line otherwise the Creditor B will not get any water. This shows that the payment of creditor B will not happen until and unless the senior lender A is paid. This payment method follows a hierarchy structure for payments.
Get complete CFA Online Course by experts Click Here
Let’s assume that AB Co borrows $250 million from Lender X (senior lender), Lender Y & lender Z. As per the waterfall payment method all the obligations of Lender X have to be paid before Lender Y & Lender Z. The Co has to pay interest and principal payments every year as follows:
$15 million and $20 million to Lender X
$10 million and $12 million to Lender Y
$3 million and $7 million to Lender Z
Assuming that the Co earns $70 million every year in cash, the lenders can be paid easily. Now assuming that the Co earns only $40 million every year, the Co must pay off $35 million to Lender X as interest and principal leaving only $5 million for Lender Y & Lender Z of which they have to be paid $ 1 million each as interest because they stand farther down in the hierarchy and has a greater risk of not getting paid in full. The result after one year is as follows:
Lender X is fully paid
Lender Y owes $9 ($10-$1) million as interest and $9 ($12-$3) million as principal
Lender Z owes $2 ($3- $1) million as interest and $7 million as principal
Assuming that the company earns $25 million in the second year, the result will be as follows:
Lender X is fully paid
Lender Y is fully paid
Lender Z owes $2($7-$5) million as principal
This example helps us understand the mechanics of a waterfall payment scheme.
This type of payment method is common for borrowers who have a large portion of debts. This provides protection to the lenders who stand higher in the debt structure as their debts are paid first. This method of payment can also be used in personal life as the basic idea is to clear the expensive debts ahead of other small debts.
Author: Urvi Surti
About the Author: Urvi is a commerce graduate and has a keen interest in Finance. She has completed her Chartered Wealth Management (CWM) from the American Academy of Financial Management and is currently pursuing a career in Financial Risk Management (FRM).