Waterfall Payment: Definition & How Does It Work

KEY TAKEAWAYS

• A waterfall payment is a type of payment made in a staggered, or “tiered,” manner. 
• In a typical waterfall structure, the borrower makes interest payments to the lender during the life of the loan. 
• At the end of the loan term, the borrower repays the remaining principal balance in a lump sum.
• Waterfall payments work in a variety of situations, including real estate transactions, business loans, and investment funds. 
• The structure of waterfall payments can be customized to fit the needs of the borrower and the lender.

What Is a Waterfall Payment?

A waterfall payment is a type of payment that is made in a series of installments, typically based on milestones being met or benchmarks being reached. In business, waterfall payments are often used in project financing, where funds are disbursed based on the achievement of certain milestones.

Waterfall payments can also be used in other contexts, such as in real estate transactions. For example, a buyer might make a series of payments to the seller based on the seller hitting certain milestones in the construction of the property.

Waterfall payments can be structured in a variety of ways, and the specific terms will depend on the agreement between the parties involved. However, there are some common features of waterfall payments.

To find out about these features and whether this structure works for you, keep reading for more information on waterfall payments.

Working Process of Waterfall Payment

A waterfall payment is a distribution of proceeds from the sale of a business or other major transaction. The senior lender often receives the first minimum interest payments. The remaining balance is then distributed in a systematic fashion.

The lower-tiered lender will receive payment according to predetermined criteria. This payment cycle is otherwise known as a “waterfall.”

Importance of Waterfall Payment

The importance makes waterfall payment suitable for a number of reasons. First, it allows for a more predictable return on investment for those creditors. Second, it may be necessary in order to protect the interest of certain creditors.

For example, suppose Creditor A is due $100 and Creditor B is due $50. But the total amount available for distribution is only $80. Then Creditor A would receive all the proceeds if there was no preference given to Creditor B.

How to Calculate Waterfall Payment?

There is no one-size-fits-all answer to this question. The amount of each payment depends on the specific terms of the debt agreement.

However, there are a few general steps to follow to calculate a waterfall payment method:

1. Determine the total amount of debt owed.
2. Divide the total debt into different tiers based on the riskiness of the debt.
3. Calculate the interest and principal payments for each tier.
4. Make the payments to the creditors in each tier according to the calculated schedule.

Waterfall Payment Example

In a waterfall payment structure, the subordinate lenders get paid after the senior lender gets paid in full. The subordinate lenders may only receive interest payments. Or they may receive a portion of the principal, as well. The method of payment can vary depending on the terms of the loan agreement.

The subordinate lenders typically get paid after the higher-tiered lender gets paid in full. If the deal goes sour, the subordinate lenders are often the first to lose their investment. As such, they usually require a higher rate of return than the senior lender.

Under this arrangement, preference goes to certain creditors over others. For example, Creditor A may get first preference in payment. Creditor B follows. Any extra payments would then go to the general pool of lower-tier creditors.

Once paying off the high-risk debt, the entire monthly payment goes towards paying down the principal of the low-risk debt.

Summary

The waterfall payment system is a type of payment system in which payments are made in a sequential order. This means that each payment is made only after the previous one has been made in full. 

This type of system is often used in construction projects, where each stage of the project must be completed before the next stage can begin. This ensures that the project is completed on time and within budget.

The main advantage of the waterfall payment system is that it provides a clear roadmap for the project. This makes it easier to track progress and ensure that each stage is completed as planned. It also reduces the risk of cost overruns, as each stage of the project is paid for separately.