What is a Waterfall Payment?
A waterfall payment is a repayment system by which senior lenders receive principal and interest payments from a borrower first, and subordinate lenders receive principal and interest payments after.
How Does a Waterfall Payment Work?
Imagine the cash generated by a company as a waterfall that flows from senior lenders down to subordinate lenders.
For example, let's assume that Big Company has borrowed $100 million from Lender A and Lender B. Lender A is 'senior' and Lender B is 'subordinate.' If Big Company is required to make waterfall payments, Lender A must be paid all its obligations before Lender B gets anything.
Assume that Big Company must pay Lender A $5 million in interest and $10 million in principal, and Big Company must also pay Lender B $7 million in interest and $9 million in principal each year.
Assuming that Big Company is able to generate at least $31 million in cash with which it pays its lenders, there is no problem. But if Big Company only makes $25 million one year, it must pay Lender A all $15 million in interest and principal, leaving only $10 million for Lender B. Because Lender B is farther down the waterfall, its loan is at greater risk of not getting paid in full. The 'water,' i.e. the cash, will get diverted to Lender A until Big Company's obligations are fulfilled.
Why Does a Waterfall Payment Matter?
Waterfall payments are common for borrowers with several tranches of debt. It protects lenders who are higher up in the debt structure.
The waterfall concept can also be used in the personal finance world as well. The idea is that a person should repay the most expensive debt first.
For example, let's assume that John has three credit cards: Card A, Card B and Card C. The interest rates on the cards are 20%, 12% and 10%, respectively. John wants to get out of credit card debt, so he decides to pay down the highest interest-rate card first. The minimum monthly payments on the cards are $150, $100 and $75, respectively.John makes waterfall payments. First, he pays the minimum on each card ($325 total) every month, and then sends Card A an extra $800. When Card A is finally paid off, he cuts it up and then applies the extra $800 per month, plus the $150 monthly payment he used to send to Card A ($950 in total) to Card B. When Card B is paid off, John applies the $800 in extra payments plus the $250 minimum payment he used to send to Cards A and B ($1,050 in total) to Card C until it is paid off.
