What is a Bullet Loan?
A bullet loan is a loan that requires a balloon payment at the end of the term. Bullet loans are also commonly referred to as balloon loans.
How a Bullet Loan Works
Bullet loans can be offered to all types of lending customers, but they are typically used in certain situations. Most bullet loans are issued for land contracts and, for that reason, are often made to real-estate developers. The term "bullet" refers to the large lump sum payment that the borrower must make at the loan’s maturity.
In a bullet loan 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 will often have the option to make no payments over the life of the loan or to make interest-only payments along the way.
[Important: Bullet loans require the borrower to make a large lump-sum payment at the end of their term.]
In a full lump sum bullet loan, 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 at maturity. In an interest-only bullet loan, the borrower is required to make regularly scheduled interest payments; this reduces the lump sum payoff at maturity to only the amount of the loan's principal.
Bullet loans are generally considered short-term financing and can be offered with varying durations, depending on how soon the borrower expects to be able to repay. They will typically charge higher rates of interest than standard loans since they do not offer as much (or, in the case of full lump sum loans, any) regular cash flow to the lender.
Bullet loans can be either secured or unsecured. Often, these types of loans are used to purchase raw land, which has a lower value as collateral than land that has been built on. 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.
Pros and Cons of a Bullet Loan
Compared with other forms of lending, bullet loans can be relatively expensive for the borrower. Their advantage is that they give real-estate developers the flexibility to borrow the cash they need to begin a building project and to structure the loan's duration based on their expectations of how long the project will take to complete. Bullet loans can also be advantageous for developers since they may not receive any cash flow from the project until it is finished and they finally have one or more buildings that they can put on the market and sell.
At that point, many building developers will use 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 old bullet loan. Take-out loans also have the advantage of better long-term financing terms than the typical bullet loan.