Bullet loans in the form of loans where the principal amount of the loan borrowed is paid back at the end of the loan tenure.
In some cases, interest expenses are added and then paid at the end of the loan term.
A bullet loan provides flexibility to the borrower; however, it undertakes more risk than other forms of debt.
In the debt schedule of bullet loans, periodic expenses consist of interest expense only and no principal payment, as this is consolidated at maturity.
In bullet loans, the borrower has to choose whether he wants to pay only the interest and bulk amounts to be paid later at maturity or as agreed with the lender.
The bullet loan terms and conditions are convenient for individuals who expect good cash flows in the future at once or some sort of investment redemption in the coming month.
The payment due at the end of the loan is referred to as the bullet payment or balloon payment.
Bullet loans are often compared with amortizing loans in which the principal amount of the loan is paid over the life of the loan.
Although there is no requirement for a loan to be either bullet or amortizing, various other forms of loans and combinations of terms exist in the market.
The loan can be partially bullet or partially amortized. Amortizing loans are however more popular in the financial market.
How does Bullet Loan work?
Bullet loans can be structured in two popular ways. In the first case, the borrower pays the interest only and the final balloon payment would be allocated for the unpaid principal.
In another case, no payments will be made at all during the loan tenure period. The entire payment will be made at the end.
Many borrowers end up paying interest throughout the term of the loan.
When interest is delayed, the amount increases, so the final lump sum would be significant at the end of the loan period.
Pros and Cons of Bullet Loans
Every borrower tends to have different requirements and sees the advantages and disadvantages of bullet loans as they deem fit to assess bullet loans. The following are the advantages of bullet loans:
- Flexibility in terms and conditions
In the case of bullet loans, individuals or small businesses get flexibility each month regarding payment. The interest and principal can be paid larger if the business has good cash flows during the month.
The borrower can pay minimum interest payments if the business has a bad month with disrupted cash flows. This gives the borrowers much flexibility in maintaining the budget moving forward.
- Comparatively lower payment amount
The primary benefit of a bullet loan has a smaller monthly payment. The borrower must pay small monthly payments for much of the loan period.
No payment of the principal amount is needed in the bullet loan until the end. If the borrower pays the interest each month, this shall result in a lower payment in the upcoming months.
- Startup and small business friendly
Bullet loans are flexible and may not require credible requirements as they undertake risk for higher returns.
Hence, they are more friendly to startups and small businesses.
These businesses get the payment terms as low as possible. Such loans can be refinanced into standard loans if required, giving businesses more options to stay in order as long as possible.
The disadvantages while availing of bullet loans are as follows:
- Lump sum payment at the end
The biggest problem with availing bullet loan is that the borrower has to pay a lump sum at the end of the loan period.
This can take the business by surprise if the estimated cash flows are not received or investments made are not redeemed or defaulted.
This would result in foreclosure of the loan and the borrower’s credibility will decline in the market. Further, the lawsuit would result in an additional headache for the business.
- Large interest payment
Bullet loans are generally unsecured. Hence, the lenders charge a higher amount of interest in the case of bullet loans. The interest payment can become higher in most cases than standard loans.
The amount of money paid over the loan life would be very high if the comparison is made to loans with standard interest rates.
- Case of refinancing
Startups and small businesses get this loan in an emergency when the orders are received and they need an injection of cash for raw materials requisition.
Hence, before the end of the loan, these are usually refinanced to more standard loans.