What is Debt Amortization?
Mandatory Debt Amortization is the contractually required repayment of the original principal by a borrower throughout the lending term.
Typically required by senior lenders, mandatory amortization reduces the outstanding debt balance and lowers the risk of loss of initial capital.
How to Calculate Debt Amortization
Risk-averse lenders can attach provisions requiring scheduled repayments of principal as part of the lending agreement.
For the borrower, the amortization of debt represents a required legal obligation to pay down debt, as opposed to a discretionary decision.
- Senior Debt Lenders: Senior debt lenders are far more likely to request some amount of mandatory amortization throughout the lending period as additional downside protection. Compared to high-yield investors, senior lenders tend to be more conservative by prioritizing capital preservation rather than chasing higher returns.
- High-Yield Debt Investors: If the debt principal is paid down, the interest expense – the fees associated with debt financing and a source of returns for lenders – also becomes lower. Therefore, high-yield debt investors, which are returns-oriented, are unlikely to require mandatory debt amortization.
The amount of mandatory debt amortization due is tied to the original debt principal – i.e. the required amortization (%) is multiplied by the original principal amount on the initial lending date.
In Excel, the purpose behind the “MIN” function is to ensure the debt balance never falls below zero, as a negative figure would imply the borrower paid off more than it initially borrowed.
Each lender will have a different risk tolerance, so the required amortization percentage varies based on which type of lender is providing the funding (e.g. corporate bank, institutional investor).
Additionally, the credit profile of the borrower can also contribute towards the required amortization, as lenders are more likely to require a higher percentage of amortization for higher-risk borrowers (and vice versa).
Debt Amortization Calculator
We’ll now move on to a modeling exercise, which you can access by filling out the form below.
Mandatory Debt Amortization Calculation Example
First, we’ll begin by listing the assumptions for our model.
In our simple example, there is just one tranche of debt: Term Loan A (TLA).
The term loan A has a tenor – i.e. the length of the borrowing arrangement – of 5 years.
- Beginning Balance (Year 1) = $200 million
- Mandatory Amortization = 20.0%
- Interest Rate = LIBOR + 200 bps
Using the first two assumptions, we can calculate the annual mandatory amortization amount by multiplying the 20.0% of mandatory amortization by the original principal amount, which comes out to $40 million per year.
The formula for calculating the mandatory amortization can be found below – note the inclusion of the “MIN” function to prevent the ending balance from falling below zero.
From Year 1 to Year 5, the borrower will pay $40m in equal installments of mandatory amortization.
Given the 5-year term of the debt, the ending TLA balance in Year 5 should be zero, as our model confirms.
Regardless of the fact that the ending balance is decreasing over time, the mandatory amortization is always calculated off the original principal amount (i.e. the $200m).
The interest expense, however, declined from $11m in Year 1 to $1m in Year 5 as a result of the gradual paydown in the principal.
While not applicable to our example, if there were any outstanding principal remaining at the end of the lending term, the balance is required to be paid entirely in one lump sum payment (i.e. a “bullet” repayment).
Ultimately, mandatory amortization for lenders is about finding the right balance between risk and return.
