What is a Leveraged Loan?

A leveraged loan is a type of loan that is extended to applications that already have a considerable amount of debt obligations. Loans of this type may be extended to individuals as well as companies. Since lenders are assuming a higher level of risk of default in order to approve the loans, the terms and conditions are often less desirable than loans extended to applicants with less accumulated debt.

As with any type of loan arrangement, a lender who provides leveraged loan services will look closely at the qualifications of the loan applicant. This means considering information obtained from credit reporting agencies, the current FICO score of the applicant, and the current income to debt ratio that the applicant enjoys. When the applicant is a business, the lender is also likely to look closely at the nature of the debt as well as whether or not payments on the obligations are current. The future prospects of the business to remain competitive in its given market or industry will also play a role in determining if the loan is approved or rejected.

Should the lender believe that the applicant for a leveraged loan meets the basic qualifications, including the ability to repay the loan within a reasonable period of time, the two parties will often begin to negotiate the terms of the loan agreement. Applicants can anticipate paying a rate of interest that is higher than the current average, simply because the lender is assuming a greater degree of risk in approving the loan. There may be other terms in the loan contract that are also less liberal than with other types of loans, a policy that further insulates the lender from the potential risk of a loan default. Assuming that the two parties can agree on the terms, the loan is issued and the debtor is free to use the proceeds to settle other outstanding debts, fund a new business project, or whatever other reason the loan was requested.

While an applicant can expect to pay a little more in interest and possibly also be subject to higher fees, the leveraged loan may be less costly in the long run. This is true if using the proceeds from the loan will position the individual or business to take advantage of current financial conditions to prepare for the future. For example, while a leveraged loan may come with an interest rate above the current average, that rate may be well below the fixed rates carried on older debt. When this is the case, the debtor actually saves money by borrowing at the lower rate on the leveraged loan and paying off the older debts with the higher rates. At the same time, this strategy also adds positive feedback on credit reports, which in turn has a positive effect on the FICO score and overall credit rating.