What is a 'Bullet Repayment'
A bullet repayment is a lump sum payment for the entirety of a loan amount paid at maturity. Loans with bullet repayments are also referred to as balloon loans, and are commonly used in mortgage and business loans to reduce monthly payments. The existence of a bullet repayment due at a loan’s maturity often necessitates advanced planning to have a refinancing facility in place, unless the borrowers have cash to pay off the lump sum.
BREAKING DOWN 'Bullet Repayment'Bullet repayments are most often a component of balloon loans, which are not amortized over the duration of the loan. The deferral of principal payments until the loan matures results in lower monthly payments during the life of the loan, but presents a significant risk to borrowers who are not prepared to make the lump sum payment or make other arrangements. Bullet repayments have also been integrated with fixed-income based exchange-traded-funds (ETFs), giving them a bond-like predictability for investors.
Bullet Repayment Versus Amortization
The difference between interest-only payments on a loan with a bullet repayment and amortizing mortgage payments can be significant. For example, on a 15-year interest-only mortgage of $320,000 with a 3% interest rate, the yearly interest is $9,600 and monthly payments are $800. The same loan with amortization has a monthly payment of $2,210.
The monthly payment schedule clearly favors the interest-only loan. However, the amortized loan is fully paid at maturity due to the higher payments, while the interest-only borrower faces a bullet repayment of $320,000. As a bullet repayment date approaches, borrowers have two primary options if money is not available to pay the loan in full. The property may be sold, with the proceeds used to pay the loan principal, or refinancing may be arranged to take out a new loan to cover the bullet repayment. Under certain circumstances, balloon lenders offer borrowers the option to convert loans to traditional amortizing loans, instead of being faced with a huge one-time payment.
Bullet Repayments and ETFs
In ETFs with bullet repayment dates, the investors assume the role of lenders, while the funds act as the borrowers. Funds with bullet repayments are usually composed of bonds, notes and fixed-income vehicles with maturities preceding the bullet repayment date. Investors receive regular interest payments on their shares during the term of the fund, and are repaid the principal from the matured portfolio holdings on the bullet repayment date. The key benefit of the bullet repayment for investors is the predictability of the return of principal on a specified date, much like the maturity of a bond.