Direct order, inverse order and pro rata application of the same prepayment, with the effect on near-term debt service, cover ratios, average life and interest.
“Inverse order of maturity” means a prepayment reduces the last scheduled instalments first, starting with the final bullet, so the borrower's next repayments do not change. On an illustrative €110m amortising term loan, a €30m prepayment applied in inverse order leaves €35m due over the next two years and a weighted average life of 2.63 years; applied in direct order it leaves €5m due and a life of 3.56 years, with €5.25m more interest (undiscounted) for the lenders.
Worked in full in How to Read a Credit Agreement by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
The application clause is one sentence in the prepayment section of a credit agreement, usually something like “applied to the remaining scheduled instalments in inverse order of maturity”, “in direct order of maturity”, “pro rata” or “as directed by the Borrower”. It changes nothing on the day of the prepayment: the outstanding balance falls by the same amount whichever words are used. It changes the repayment profile for the rest of the loan, and with it the borrower's liquidity, its debt service covenant and the lenders' interest income.
| Item | Value |
|---|---|
| Original amount | 120.0 |
| Scheduled instalments, years 1 to 5 | 10.0 / 15.0 / 20.0 / 25.0 / 50.0 |
| Outstanding after the year 1 instalment | 110.0 |
| Voluntary prepayment at the start of year 2 | 30.0 |
| All-in interest rate | 7% |
| EBITDA less capex, year 2 | 40.0 |
Direct order: the next instalment first. Year 2's 15.0 goes to zero and year 3's 20.0 falls to 5.0.
Inverse order: the last instalment first. The year 5 bullet of 50.0 falls to 20.0; years 2 to 4 are untouched.
Pro rata: every remaining instalment falls by 30.0 ÷ 110.0 = 27.27%.
Weighted average life = Σ(years from now × instalment) ÷ Σinstalments. Excel: =SUMPRODUCT(Years,Instalments)/SUM(Instalments)
| Application | Year 2 | Year 3 | Year 4 | Year 5 | WAL (years) |
|---|---|---|---|---|---|
| No prepayment (€110.0m) | 15.00 | 20.00 | 25.00 | 50.00 | 3.00 |
| Direct order | 0.00 | 5.00 | 25.00 | 50.00 | 3.56 |
| Inverse order | 15.00 | 20.00 | 25.00 | 20.00 | 2.63 |
| Pro rata | 10.91 | 14.55 | 18.18 | 36.36 | 3.00 |
| Application | Due in years 2 and 3 | Year 2 debt service | Year 2 fixed charge cover | Interest to maturity, undiscounted |
|---|---|---|---|---|
| Direct order | 5.00 | 5.60 | 7.14x | 19.95 |
| Inverse order | 35.00 | 20.60 | 1.94x | 14.70 |
| Pro rata | 25.45 | 16.51 | 2.42x | 16.80 |
Direct order gives the borrower an amortisation holiday: nothing due in year 2 and only €5.0m in year 3. Its fixed charge cover for year 2, computed as 40.0 over debt service, jumps to 7.14x. The cost is a longer loan: the remaining €80.0m stays out longer, and the lenders earn €19.95m of interest to maturity.
Inverse order keeps the original amortisation in place and shortens the loan instead. The next two years still require €35.0m, cover in year 2 is 1.94x (against 1.76x had nothing been prepaid), and the bullet shrinks to €20.0m, which reduces refinancing risk at maturity. Interest to maturity is €14.70m, €5.25m less than under direct order. Pro rata sits between the two and preserves the original weighted average life of 3.00 years.
None of the three choices changes the year 2 interest of €5.60m, because the balance is €80.0m in every case on the day after the prepayment. The differences open up only from year 3 onwards, which is why a one-year forecast can miss them entirely while a model run to maturity shows them clearly.
| Prepayment | Due yrs 2 and 3, direct | Due yrs 2 and 3, inverse | WAL, direct | WAL, inverse |
|---|---|---|---|---|
| 10.0 | 25.00 | 35.00 | 3.20 | 2.90 |
| 30.0 | 5.00 | 35.00 | 3.56 | 2.63 |
| 50.0 | 0.00 | 35.00 | 3.83 | 2.17 |
| 70.0 | 0.00 | 35.00 | 4.00 | 1.75 |
Under inverse order the near-term schedule never moves, whatever the size of the prepayment, until the prepayment is large enough to eat through the bullet and year 4. Under direct order a €70.0m prepayment buys three years with nothing due.
Modelling every prepayment as reducing the next instalment. A model built that way shows the borrower with €5.0m due over two years when the agreement, read correctly, requires €35.0m: a €30.0m liquidity gap and a year 2 cover ratio of 7.14x that is really 1.94x. The reverse error, applying inverse order where the borrower may direct, understates the flexibility the borrower has bought. The application words sit next to the break cost and premium provisions; model them from the same clause.
Inverse order of maturity applies a prepayment to the last instalments first: the outstanding balance falls, the next repayments do not, and the loan gets shorter. On the illustrative €30m prepayment that means €35m still due in two years against €5m under direct order, and €5.25m less interest for the lenders. The full facility, with its amortisation, sweep and covenants run quarter by quarter, is in the free workbook for this case.
Direct order applies a prepayment to the next scheduled instalments, giving the borrower an amortisation holiday. Inverse order applies it to the last instalments, starting with the bullet. On an illustrative €30m prepayment of a €110m loan, direct order leaves €5.0m due over two years and inverse order €35.0m.
No. Reducing every remaining instalment by the same percentage keeps the shape of the schedule, so the weighted average life is unchanged. In the example each instalment falls by 27.27 per cent and the life stays at 3.00 years, between 3.56 under direct order and 2.63 under inverse order.
Because the amortisation they underwrote keeps running and the exposure shortens, while the borrower cannot turn one prepayment into years without repayments. In the illustrative case inverse order keeps €35.0m due in the next two years and cuts the final bullet from €50.0m to €20.0m.
This article is one calculation from How to Read a Credit Agreement. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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