Bullet Loan: Definition, How It Works, Formula, Vs. Amortizing

What Is a Bullet Loan?

A bullet loan is commonly referred to as a balloon loan that requires a balloon payment, usually a large balance, and a final payment due at the maturity of a loan.

Throughout the borrowing period, the only payment made, if any, is the interest expense, and the original principal borrowed is paid at the end of the lending term. Bullet loans are more common in commercial real estate than in residential real estate.

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.

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.