Bullet Loan

What Is A Bullet Loan?

A bullet loan, or a balloon loan, refers to a type of loan where the borrower does not make any principal, interest, or minimal payments until the maturity date of the loan. This means that, at the maturity date, the borrower makes a single balloon payment that covers the loan balance with interest.

Therefore, borrowers taking balloon loans are usually not liable for monthly payments over a fixed term. The borrower must prepare for the maturity date as it requires a lump-sum payment to the lender. Such a payment is also referred to as a "bullet" or "balloon payment".

The unpaid interest on a balloon loan still accrues as generally for a traditional monthly payment debt scheme. However, the payment for such a loan is further into the future. Hence, the interest usually accrues more than a conventional loan given a more extended period.

Usually, most balloon loans are structured so that the borrower pays only part of the interest to the lender as monthly payments, meaning that most of the loan balance is collected at the end. This allows borrowers to not worry about monthly payments.

Since balloon loans are structured this way, they usually are issued for just a few years, making them a short-term financing option. However, they can be structured in other methods based on the borrower's requirements.

How A Bullet Loan Works?

Balloon loans can be secured or unsecured. If they are secured, the loan is backed by collateral, which the lender can liquidate if the borrower defaults. However, if they are unsecured, the lender loses the entire loan amount in the event of a default.

Qualifying for this type of loan is very similar to a traditional fixed-rate loan. The process involves income verification, credit score check, asset verification, and computation of the borrower's debt-to-income ratio.

The credit check may be slightly more stringent, given that the borrower must make a huge lump-sum payment at maturity. Thus, lenders may have stronger criteria for approval.

The payments on a loan can be calculated using the following formulas:

Monthly Payment = (L * i * (1 + i)ⁿ) / ((1 + i)ⁿ - 1)

The following formula computes the balance due after the term of a bullet or balloon loan, i.e., the bullet payment:

Bullet payment = (L * (1 + i)ⁿᵇ) - Payment/i * ((1 + i)ⁿᵇ - 1)

Where:

• L = Loan amount

• i = periodic interest rate

• n = Number of periods

• nb = Number of bullet loan periods

Purpose of a Bullet Loan

Bullet loan is used in various spaces where borrowers prefer not to make monthly payments on their loan but a lump sum at the end. These loans are quite common in the real estate industry.

For instance, undeveloped land is purchased by a borrower. In such an investment, the borrower hopes to add value to the real estate and sell it at a later date to turn a profit. Using this kind of loan, part of the lump sum received from the sale can be used to pay the lender.

Now, let us take a look at how bullet loans are used in different sections.

Bullet Loans in Real Estate

Although it is a more popular financing option in commercial real estate, many investors use balloon loans to add value to residential properties. Then, they sell the property before the maturity date to have sufficient capital to make the payment.

In such a scenario, an investor would seek financing that allows them to limit their cash flows as much as possible in the short to immediate term, giving them time and capital to make renovations. This is referred to as a value-added investment in real estate.

Bullet Loans for Development Projects

Loans with a maturity structure with a lump-sum payment at maturity are also applicable for development projects. Large developers need the flexibility and structure of a bullet loan to allow them to develop land from the ground up and then sell it in the future.

The developer would use the sale amount to pay back the lender at maturity while, ideally, reaching their target returns based on their projected risk. This type of investment is commonly referred to as an opportunistic endeavor in real estate.

Variety of Use Cases in Real Estate Investment

Interest-only payment terms and no-payment-terms loans are commonly used in real estate investment by firms and individual investors. This is because there are various ways that individuals and firms can use such financing to meet their needs.

These specific use cases may be untraditional and vary from borrower to borrower. For instance, a borrower may simply decide to take a bullet loan to benefit from the low monthly payments by investing that difference into a different project with higher returns.

Borrowers are often creative with their financing needs and purposes. They will consider several options from the lenders that try to serve them.

Bullet Loan Example

In this section, we will consider a simple, practical scenario explaining the application of bullet loans and the factors associated with such a debt structure for borrowers.

Let's say you are a real estate developer who finds under-market and under-rented residential properties to add value through renovations. You have recently found a house listed at $250,000, which you see potential in.

This property has many challenging design issues, which is why it is listed at a 40% discount compared to other homes in the same neighborhood. You believe you can create value in the property to bring it up to the market price.

Given that you are planning to sell the property after renovations are completed, instead of renting for cash flows, you plan that your renovations will need about two years and cost $50,000. 

Thus, you find that this kind of loan works well for such an opportunity, as you don't need to worry about making monthly payments and can focus all your capital on renovations to add value to the home.

Therefore, you take a bullet loan of $300,000, which covers your home acquisition and renovation costs. You can pay back that loan in a lump sum in 2 years, allowing you time to make renovations and then sell the property for at least $350,000, given the home's new value.

Advantages and Disadvantages of a Bullet Loan

Although a balloon loan can appear to hold the great advantage of having negligible or no monthly payments, individuals and firms need to consider the risks associated with this debt option. 

The table below highlights the factors associated with a bullet loan:

A balloon loan's biggest drawback is that the lump-sum payment at maturity can hit the borrower by surprise. Therefore, careful planning and capital management are required for the borrower to have the ability to make the required payment in total comfort.

Since lenders consider this loan riskier than other debt options, they charge higher interest rates to compensate for the risk. Moreover, the approval requirements for such a loan may be tighter.

However, they are the best option for some, even given these drawbacks. The borrower can use the terms of the loan to their advantage by using the low monthly payments to generate even more income through reinvestment into a project.

To add, borrowers can use such financing to invest in projects with low monthly cash flows and a focus on a large lump-sum payment in the future. Although risky, the balloon loan provides capital for such an endeavor.

Additionally, balloon loans are quite famous for new startups or businesses looking for financing. This allows the new business time to grow before balloon payment.

Lenders recognize the value that such a debt structure offers startups, causing most lenders to offer this loan option. Moreover, even if the startup cannot meet the balloon payment, it can simply refinance the loan into standard debt.

Another significant advantage offered through balloon debt is that the borrower has the flexibility to make monthly payments of interest based on their comfort.

For instance, a borrower may decide to make a prepayment for both the interest and principal in a well-performing month if they wish to lessen the burden of the balloon payment. 

Therefore, there are ways to reduce the stress of the final amount due for a bullet loan.

Bullet Loan Vs Amortization Loan

Individuals should be aware of the factors associated with a bullet loan and a traditional amortizing loan. This can help individuals analyze which debt structure fits their needs best.

The table below highlights the key points associated with both debt structures:

The most crucial difference between a balloon loan and a traditional amortizing loan is the payment schedule, as a balloon loan has low or no monthly payments.

The borrower needs to understand which payment schedule works better for their capital needs. This is because the lender, in either case, has dramatically different expectations of when they plan to receive payments and how much each should be.

Additionally, these loans are usually riskier for both the borrower and the lender, the higher interest rate for such a payment schedule should also be part of the analysis. 

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Baseline
• Interest
• Liability
• Macrofinance
• Proxy Vote