What is a Waterfall Payment?
How Does a Waterfall Payment Work?
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?
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.
Personalized Financial Plans for an Uncertain Market
In today’s uncertain market, investors are looking for answers to help them grow and protect their savings. So we partnered with Vanguard Advisers -- one of the most trusted names in finance -- to offer you a financial plan built to withstand a variety of market and economic conditions. A Vanguard advisor will craft your customized plan and then manage your savings, giving you more confidence to help you meet your goals. Click here to get started.
Read This Next
Traders find success along many paths, but most follow discretionary or systemic trading rules. Discretionary traders buy and sell based upon what they think is going to happen in the markets....Read More →
A sharp plunge on Monday, a stunning rebound Tuesday, another pullback Wednesday. When will it all end? It's increasingly clear that very low...Read More →
When you were a child, security items probably filled your childhood with peace of mind. Things like a blanket, stuffed animal or pillow might have protected you from monsters under the bed or...Read More →