What is a Bullet Loan?
A bullet loan is a type of loan in which the principal that is borrowed is paid back at the end of the loan term. In some cases, the interest expense is added to the principal (accrued) and it is all paid back at the end of the loan.
This type of loan provides flexibility to the borrower but it is also risky. In a debt schedule, periodic expenses would only consist of interest expense and no principal payment, as this is consolidated at maturity.
All of these terms essentially mean that a borrower is going to be making a large payment only at the end of the repayment term. With a bullet loan, borrowers can sometimes get access to loans they would not be able to afford as a regular, long-term loan with a monthly payment schedule.
Below is an example of principal repayment profiles for various different types of loans.
How a Bullet Loan Works
Most bullet loans are issued for land contracts to real-estate developers. A bullet loan does not fully amortize over the term of the note, thus leaving a large principal balance due at maturity. The term “bullet” refers to the large lump sum payment, usually the full value of the principal, due at the loan’s maturity.
A borrower is approved for a maximum principal amount determined through the customary underwriting process. The loan can then be structured in several different ways, depending on how the borrower wants to repay it.
Bullet loan borrowers may be offered a zero payments option over the life of the loan or interest-only payments.
When a zero payment loan is offered, interest will accrue according to the loan terms, usually monthly or annually, and the borrower will be required to pay the total balance in the form of a large lump sum of both principal and accrued interest at maturity.
In an interest-only bullet loan, the borrower is required to make regularly scheduled interest payments. This reduces the bullet or balloon payment at maturity to the amount of the loan’s total principal.
Bullet loans are generally considered short-term financing and can be offered with varying durations, depending on how soon the borrower expects to repay. Due to the flexibility provided to borrowers, lenders typically charge higher rates of interest for bullet loans.
Bullet loans can be secured or unsecured. Often, bullet or balloon loans are used to purchase undeveloped land, which provides less collateral than a fully developed property. Some developers may choose to buy single tracts of land with bullet loans, while others may use a bullet loan for developing an entire subdivision with multiple tracts of land.
“Full” Lump Sum Bullet Loan
Considering how customizable bullet loans tend to be, the interest can be negotiated to be in the form of paid-in-kind (PIK) interest, which further increases principal due at maturity (and the credit risks) as the interest accrues to the ending balance.
If structured as PIK interest, the principal is equal to the original debt capital provided plus the accrued interest, with the interest expense growing each year from the increased debt balance.
Advantages of Bullet Loan
- Bullet loan provides flexibility to the borrower, especially the real-estate developers.
- The loan is advantageous for a company with a short-term cash flow problem.
- People who are short of money and expecting to receive money in the near term can avail it.
- Bullet loans come with an option wherein paying the interest monthly or yearly reduces the financial burden on the borrower at the time of repayment of the loan.
- The bullet loan is quite good for new business entities as it provides flexibility to borrow cash as and when needed.
Disadvantages of Bullet Loan
- The bullet loan involves a risk factor as it involves heavy payment at the end; the borrower may not have made preparations to repay the loan in one go.
- The loan may incur a huge lump-sum interest payment at the end of maturity
- A bullet loan comes with a high rate of interest.
- The loan may require refinancing, and the borrower may end up incurring more closing tasks.
Pros and Cons of a Bullet Loan
Bullet loans offer the advantages of lower interest-only or zero payments and loan structure flexibility. However, bullet loans may also have a relatively higher interest rate and the disadvantage of the large payment at the end of the loan term.
Developers often initially benefit from a bullet loan on a building project and structure the loan’s duration based on their expectations of how long the project will take to complete. However, developers may not receive cash flow from the project to support regular loan payments until it is finished when they have real property to sell to pay for the cost of the loan. The bullet payment may come due as well before cash flow has started.
Many builders opt for a take-out loan to refinance their debt. In a take-out loan, the borrower offers the newly completed buildings as collateral for a new loan and then uses that money to pay off the existing bullet loan.
Bullet loans are a useful tool for businesses in a short-term liquidity crunch, but banks require a high Loan-to-Value ratio. The value of the asset should cover the loan amount by a good margin. Loan-to-Value is defined as this.
Usually, in a bullet loan, banks require 75% of the loan to be covered by the asset value. This is so they can sell it and get repaid in case of delays in payment.