What it is:
How it works (Example):
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.
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 it Matters:
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.