Senior term debt is a loan with a priority repayment status in case of bankruptcy, and typically carries lower interest rates and lower risk. The term can be for several months or years, and the debt may carry a fixed or variable interest rate.
To reduce repayment risk, fixed assets are frequently used as collateral – a first lien on current assets, intangibles, or even the borrower’s stock is also used for security. Senior term debt is the main product provided by commercial and corporate departments of a bank.
How Senior Term Debt is Structured
A senior term debt has an amortization schedule, where the borrowing company will have to pay the fixed installments of interest and principal. What makes senior term debt different than a regular debt is that it can include a bullet payment at the maturity date. It means paying the remaining value of the debt that is owed to the lender.
Some term debts only require paying the interest, where the initial principal is paid as a balloon payment at the end of the loan term. The difference is that in a bullet payment, the repayment may contain both interest and principal amounts.
The “interest-only” arrangement with a balloon payment at the end allows the company to keep more cash flow in the business to fuel operations when the company needs it the most. Therefore, the payment at the end will be far greater than the regular payments made. The maturity of a term debt is determined based on multiple factors, including the ability of a company to repay the debt, the useful life of the financed asset, and the purpose of the debt.
Straight-Line or Accelerated Amortization
When there is principal amortization along with interest payments, the amortization can either be straight-line or accelerated. The straight-line method is considered a simple method of debt repayment. It divides the principal and interest into an equal number of payments, so the payments remain constant throughout the period. It is also known as a fixed payment loan.
With the accelerated method, the borrower is allowed to make extra payments that will be added to the regular principal payments. The method’s benefit is a faster reduction of the amount owed, saving the borrower money on interest payments. It is due to a reduction in the principal amount, meaning a reduced interest expense. It is also known as a fixed principal loan. We also provide a Fixed Principal Loan Calculator.
The interest rate is typically set using a spread plus LIBOR, which is an equivalent rate to the federal fund’s rate and is the short-term interest rate that leading banks around the world charge each other. The spread, measured in basis points, is predetermined and can increase or decrease based on the creditworthiness of the borrower. The interest rate can either be fixed or, most commonly, variable.
When a company has issued multiple debts, it will have a debt schedule in its financial model that tracks the company’s total debt balance, cash balance, and interest expense for the forecasted years. Senior term debt is often the simplest component of the debt schedule because of its predictability. For the forecasted period, the repayment amounts will be known with certainty, especially with fixed interest rates and set payments.
Why use Senior Term Debt?
Companies have varying objectives for using debt. When they structure their financing, it is common to see a full suite of debt products that includes senior term debt, as well as senior revolving debt, where the former is sometimes combined or even subordinate to the latter.
Senior term debts are used to raise capital for specific, and often temporary, objectives such as acquisitions, buyouts, refinancing, recapitalizations, or fixed asset purchases, which will require a huge lump sum. Senior term debt will spread these expenses, which are fairly large, over several years, and will be matched by the cash flows the company will generate so the company can make timely payments.
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