Bullet loans in the form of loans where the principal amount of loan borrowed is paid back at the end of the loan tenure. In some cases, interest expenses are also added and then paid at the end of the loan term.
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 amount and bulk amount to be paid later at the time of maturity or as agreed with the lender.
The bullet loan terms and conditions are convenient for individual who expect to have good cash flows in the future at once or some sort of investment redemption in the coming month.
The payment that is 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 whose case the principal amount of loan is paid over the life of loan.
Although there is no requirement for a loan to be either bullet or amortizing, various other forms of loans and combinations of terms do exist in the market. The loan can be partially bullet or partially amortizing. 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 first case, the borrower pays the interest only and final balloon payment would be allocated for the unpaid principal.
In another case, no payments will made at all during the period of the loan tenure. The entire payment will be done at the end. Many borrowers end up paying interest throughout term of loan.
When interest is delayed, the amount increases and so the final lump sum would be significant at the end of the period of the loan.
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 in order to assess bullet loans. The following are the advantages of bullet loans:
- Flexibility in terms and conditions
In case of bullet loans, the individuals or small businesses get flexibility each month with regards to payment. If the business has good cash flows during the month, the amount of interest and principal can be paid in larger amount.
If the business has a bad month with disrupted cash flows, the borrower can just pay minimum interest payment. This gives the borrowers a lot of flexibility in maintaining the budget moving forward.
- Comparatively lower payment amount
The primary benefit of availing bullet loan is to have smaller monthly payment. For much of loan period, the borrower is required to pay small monthly payment.
No payment of the principal amount is needed in bullet loan until the end. If the borrower is paying 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 the additional options to businesses to stay in order as long as possible.
The disadvantages while availing bullet loans are as follows:
- Lump sum payment at the end
The biggest problem with availing bullet loan is that borrower has to pay lump sum at the end of period of loan. This can take the business by surprise if the estimated cash flows are not received or if investments made are nor redeemed or defaulted.
This would result in foreclosure of loan and the credibility of borrower will decline in the market. Further, the lawsuit would result in additional headache for the business.
- Large interest payment
Bullet loans are generally unsecured. Hence, the lenders charge 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 that would be paid over the life of loan would be very high if 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.