A bullet loan is a type of loan that requires a large lump sum repayment at maturity. It is also called the interest-only or a balloon loan.
Bullet loans offer several advantages to borrowers. These loans are often used in the real estate sector. Companies use these loans to fund specific projects or equipment leasing. However, these loans can pose some risks such as interest rate risk for the borrowers. Also, these loans come with higher default risk as they require a large payment at maturity.
Deeper Definition
A bullet loan is a type of loan that requires a large or balloon payment at the end of the loan term. The accrued portion of the loan can either be the principal amount or deferred interest until maturity.
Borrowers make regular payments in a bullet loan as in any other common type of loan. The installments of a bullet loan are often made to cover the principal only. The interest accrues over time and the borrower makes the payment at maturity. Conversely, the borrowers would make the payments that include only the interest portion, and the principal would become payable in a lump sum payment at maturity.
How Does a Bullet Loan Work?
Lenders approve bullet loans after appraising the creditworthiness of the applicant as in any other loan application. As these loans require a risky large payment at the end, the lenders may use stricter approval criteria. For secured bullet loans, lenders require collateral.
These loans are considered short-term financing solutions. Corporate borrowers often use these loans to fund specific projects such as real estate, construction, and equipment leasing. These loans are suitable for company projects that expect immediate cash inflow after completion.
Bullet loans come with higher interest rate costs than other loans. These loans can be either secured or non-secured. A secured form of bullet loan is used for individual borrowers such as for a house mortgage. Unsecured loans may come at higher costs for the borrowers. Also, unsecured loans are risky, hence lenders may not approve the loan application. These loans are issued to borrowers with high credit scores and established credit history.
Special Considerations with a Bullet Loan
A bullet loan can be structured in different ways. It has several uses such as a mezzanine loan, senior loan, payment in kind loan, etc.
The repayment schedule of these loans can also be structured differently. For instance, a borrower may make interest-only payments until maturity. Contrarily, the borrower may make principal repayments and the interest is accrued over time. Both types will involve a large lump sum payment at the maturity time.
These loans are considered short-term financing solutions. These loans typically range from one year to five years of loan terms. However, a shorter term means higher installment payments and a larger lump sum payment at the end.
It is a common practice for borrowers to refinance the balloon payment at maturity. Borrowers can refinance the large payment due at maturity in several ways. A common practice is to seek refinancing with an amortized loan. Else, refinancing can also be made into another conventional loan. Either way, the lender will decide new terms of refinancing with new interest rates and terms.
Example
Suppose a borrower takes a bullet loan of $ 300,000 with a 5% interest rate and a 10-year term.
The borrower would make $ 1,610.46 monthly installments for 119 months before maturity. The total interest paid on the loan will be $ 137,282. Hence, the balloon payment at maturity would be $ 245,637.
Advantages of a Bullet Loan
A bullet loan can offer several benefits to borrowers.
- Borrowers require no prepayment with this loan.
- Borrowers can use the flexible terms of low monthly payments for business advantage.
- For short-term loans, the qualification of borrowers is easier than long-term loans.
- These loans can be used as secured or non-secured types of loans.
- Borrowers have the option of refinancing at maturity for the large lump sum payment.
Disadvantages of a Bullet Loan
A bullet loan can be risky and offer some disadvantages to borrowers.
- It poses a higher default risk due to large balloon repayment at maturity.
- Lenders consider it risky, hence charge higher interest rates.
- These loans offer interest rate risks, increased interest rate risks may require refinancing the loan terms altogether.
- Obtaining a refinancing facility can be difficult at maturity for many borrowers.
- Lenders can attach stricter conditions with a risky loan such as a bullet loan.
Conclusion
A bullet loan comes with a large lump sum payment at maturity. It is a short-term loan with different structures. Borrowers may need to make interest-only payments and one large repayment for principal at maturity. However, a bullet loan can be risky as it poses higher interest rates and default risks.
