What is a waterfall payment?
Higher-tiered creditors must get interest and principal payments under waterfall payment systems. In contrast, lower-tiered creditors must receive central charges only when the higher-tiered creditors have been fully reimbursed. Because these loans are probably the most costly, debtors usually organize these programs into tranches and prioritize the loans with the most significant principle first.
How a Waterfall Payment Works
Picture a waterfall that empties into buckets arranged vertically. The buckets stand in for creditors, and the water symbolizes money. The first bucket is filled with water initially. Only after the first bucket is filled will the second begin to fill. More buckets fill in the order they appear as the water flows.
The debt (bucket) usually becomes smaller as the water level drops. This is because paying off enormous debts lowers the possibility of bankruptcy and frees up funds for business expenses, investments, and capital projects.
This kind of arrangement, for instance, works well for a business that repays many loans. Suppose there are three operational loans for this firm with varying interest rates. For the most expensive loan, the corporation pays back principle and interest; for the other two, it merely pays interest. The business may pay all interest and focus on the following, more costly loan once the first, more expensive loan has been paid off. Until all loans are returned, the procedure is repeated.
A Waterfall Payment Example
Assume a corporation has taken out loans from three creditors, A, B, and C, to illustrate how a waterfall payment plan works. Because of how the program is set up, Creditor A is the creditor with the highest tier, and Creditor C has the lowest level. The following is a breakdown of the amounts that the corporation owes each creditor:
Ten million dollars in principle plus five million dollars in interest are owed to creditor A.
Eight million in principle plus $3 million in interest are payable to creditor B.
$5 million in principle plus $1 million in interest are owed to creditor C.
Let’s say the business makes $17 million in its first year. After that, it pays Creditor A the total $15 million owed, leaving it with $2 million to settle other bills. Creditor B must get this $2 million since the priority system is still in effect. Assume the business gives Creditor B $1 million in principle and $1 million in interest. After the first year, the outcome is as follows:
We have paid Creditor A in total.
$2 million in interest and $7 million in principal are owed to creditor B.
$5 million in principle plus $1 million in interest are owed to creditor C.
If the business makes $13 million in the second year, it might settle its outstanding debt with Creditor B and start making payments to Creditor C. After the second year, the outcome is as follows:
We have paid Creditor A in total.
B’s credit has been paid in full.
The principal owing to Creditor C is $2 million.
Simplifying this example was to illustrate how a waterfall payment plan works. Many waterfall systems are designed to send minimal interest payments to every tier during each payment cycle.
Conclusion
- Higher-tiered creditors may receive principal and interest payments before lower-tiered creditors under waterfall payment schemes.
- Until the higher-tiered creditors are fully paid, lower-tiered creditors get interest-only payments.
- One debt at a time, or all loans paid out in one go, may be paid off using waterfall payments.
