A leveraged loan is a high-risk loan made to borrowers who have a lot of debt, poor credit, or both. Lenders often charge a higher interest rate because there is a greater risk of default. Leveraged loans are often used by businesses.
Here’s what to know about leveraged loans, how they work, and their advantages and disadvantages.
Definition and Examples of Leveraged Loans
Leveraged loans are provided to borrowers that have high levels of debt and/or low credit ratings. Both bank and non-bank lenders can make leveraged loans. This type of loan is often used by companies to finance mergers, acquisitions, or leveraged buyouts. Leveraged loans play an important role in the economy by enabling essential borrowing for less-qualified borrowers.
There’s no exact criteria for when a loan is leveraged, and no regulatory agency has specifically defined what type of loan constitutes a leveraged loan. Individual lenders establish their own policy for when a loan is considered leveraged. Lenders typically consider the overall risk of each borrower, the cost of the loan, and the amount of debt the borrower has.
For example, a leveraged loan could be made by a bank to a low-rated corporate borrower whose debt is five times its earning. The leveraged loan may be used to finance the acquisition of another business.
The leveraged loan market was approximately $1.2 trillion in 2019, according to an FDIC analysis of S&P Leveraged Commentary and Data.
How Leveraged Loans Work
Individual financial institutions define their own criteria for when a loan is considered a leveraged loan. Lenders look at the overall risk a borrower presents based on credit rating, existing debt, and other financial factors.
Most leveraged loans have higher interest rates than other types of financing. This is due to the added risk lenders are taking on. Leveraged loans also often have a variable interest rate. That means the interest rate can change over time, in contrast to fixed-rate loans where the rate remains the same throughout the repayment period. Many leveraged loans have their interest rate tied to the London Interbank Offered Rate (LIBOR), which is based on the rates banks charge one another for lending overnight.
LIBOR is expected to be discontinued after 2021. Banks may need to use a different reference rate for future leveraged loans.
Some leveraged loans include "maintenance covenants." These covenants require borrowers to continue to meet certain criteria with regard to their financial performance in order to not violate the loan agreement. Loans with maintenance covenants are seen as less risky, but leveraged loans don’t often include these covenants anymore.
Lenders often pass the risk of leveraged loans on to investors. A growing number of banks operate under an "originate-to-distribute" model with regard to leveraged loans. This means banks issue the loans but the loans are actually funded by collateralized loan obligations (debt-backed securities) or loan mutual funds. Investors may choose to buy leveraged loan funds because the higher interest rate on these loans can provide higher returns, and because the floating rate on these leveraged loans provides some protection against rising rates.
Advantages and Disadvantages of Leveraged Loans
Leveraged loans can be used by businesses to finance mergers and acquisitions. They enable borrowing even when the business has a low credit rating. Leveraged loans also allow lenders and investors to earn a higher rate of interest, which may be more profitable.
However, borrowers face higher interest costs with leveraged loans. These interest costs could increase over time for borrowers due to the floating interest rate. Lenders also face a greater risk of borrower default since borrowers tend to have high amounts of debt and/or low credit ratings. That means the loan is at risk of not being repaid.
Should I Get a Leveraged Loan?
Leveraged loans are popular with businesses. If you’re an individual borrower looking to secure a loan for personal reasons, you may be better off with a different type of loan. Even if your credit score isn’t the best, you may be able to get a secured loan or a personal loan for bad credit. If you own your home, a home equity loan or home equity line of credit (HELOC) may also be an option. Consider all of your lending options before applying.
- Leveraged loans can be made by bank and non-bank lenders to borrowers with high amounts of debt and/or low credit ratings.
- Leveraged loans are most often used by businesses for mergers, acquisitions, or leveraged buyouts.
- The interest rate on a leveraged loan tends to be higher than the rate borrowers may get on other types of loans.
- Leveraged loans generally have variable interest rates, which are tied to LIBOR (although LIBOR is expected to be discontinued after 2021).