'Waterfall Payment'

What is a 'Waterfall Payment'

Definition-1

A waterfall payment is a type of payment scheme in which higher-tiered creditors receive interest and principal payments, while the lower-tiered creditors receive only interest payments. When the higher tiered creditors have received all interest and principal payments in full, the next tier of creditors begins to receive interest and principal payments.

Definition-2

A contractual loan repayment plan established by a debtor organization that prioritizes payments to multiple creditors based on the size or expense of the loan. Debtors will cascade their loans in a way that eliminates the more expensive loans with larger principal payments while making minimum interest payments to the less expensive loans.

Definition-3

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 it works (Example):

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 ABC Company has borrowed Rs.100 million from Lender A and Lender B. Lender A is "senior" and Lender B is "subordinate." If ABC Company is required to make waterfall payments, Lender A must be paid all its obligations before Lender B gets anything. 

Assume that ABC Company must pay Lender A Rs 5 million in interest and Rs10 million in principal, and ABC Company must also pay Lender B Rs 4 million in interest and Rs 9 million in principal each year.

Assuming that ABC Company is able to generate at least Rs 31 million in cash with which it pays its lenders, there is no problem. But if ABC Company only makes Rs25 million one year, it must pay Lender A all Rs15 million in interest and principal, leaving only Rs10 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 ABC Company's obligations are fulfilled.

Why it Matters:

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 Ram has three credit cards: Card A, Card B and Card C. The interest rates on the cards are 20%, 12% and 10%, respectively. Ram 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 Rs15000, Rs10000 and Rs7500, respectively. Ram makes waterfall payments. First, he pays the minimum on each card (Rs32500 total) every month, and then sends Card A an extra Rs80000. When Card A is finally paid off, he cuts it up and then applies the extra Rs 80000 per month, plus the Rs15000 monthly payment he used to send to Card A (Rs95000 in total) to Card B. When Card B is paid off, Ram applies the Rs80000 in extra payments plus the Rs25000 minimum payment he used to send to Cards A and B (Rs105,000 in total) to Card C until it is paid off.