So how exactly does a bullet loan differ from other types of business loans? And what's more, is it worth looking into for your company? Basically, with a bullet loan, you can defer repaying the principal until term's end—you may even be able to defer the interest payment also. There are some risks involved however, that you definitely want to be aware of going in. In this article, we discuss the structure of the bullet loan in order to better help you understand what this kind of financing is all about.
The Fundamentals of the Bullet Loan
Also called a balloon loan at times, a bullet loan is due upon reaching maturity. That is to say, there's no amortized repayment schedule in which you pay the principal plus interest until the end of the term. Here, repayment of the principal comes at the end of the whole term, requiring that you then remit a lump sum payment covering the total unpaid amount. This is what is known as a balloon payment in light of the rather large amount that you are paying at that time.
This could work for you for a number of reasons. First off, you have lower monthly payments as you're only paying on the interest of the loan—not principal. Because of the difference in repayment versus a more traditional business loan, bullet loans are generally considered in the short term. They're commonly used for example by real estate developers to acquire commercial land.
How Bullet Loans Work
This type of loan can be structured in two ways:
- You pay interest only and then the final balloon payment will be for the unpaid principal.
- No payments at all throughout the duration of the term; at maturation, you will then pay the entire amount due.
Most do end up paying interest throughout the term of the loan. With delaying the interest as well, the amount increases and so that final lump sum can be a pretty significant amount to have to pay come to the end of the allotted period.
For such loans, given the structure, usually, the term does not exceed five years. Interest though can be amortized which in turn will increase the total you will pay. Usually, the payments are scheduled monthly—if you do go with no payment until the end then you would only pay at the term's conclusion.
Keep in mind, balloon payments can be quite large. Many borrowers, for this reason, end up refinancing once the loan reaches maturity. Because they've had low payments throughout, they are generally able to put more into the business and thus actually be in a position to refinance at the end.
Some Examples
As mentioned, these loans are used frequently in real estate transactions. A development company may get a bullet loan to buy undeveloped land. With the funding from the loan, they are then in a position to develop this land and create properties, thus increasing the land's value. Now that the property is developed, this becomes collateral to refinance with at the end of the term.
Also, businesses have used bullet loans to finance building a new structure/facility. Again, once it is built, the company then can utilize this as collateral for refinancing purposes. Some also have used bullet loans for purchasing new equipment. The equipment can assist with projects which create more revenue and therefore help that business to refinance.
Understanding the Pros and Cons of Bullet Loans
As noted earlier, there are going to be some risks. It's important to look at all sides in determining whether or not this is the right loan product for you.
Pros
Qualifications - Many who might not otherwise qualify for traditional business loans, do find that a bullet loan is easier to get approved for. This is large because they have a shorter term and are in general considered riskier.
Lower Payments - Of course, that final payment is a big one. But throughout the duration of the loan, you are most likely just paying the interest, which means the principal is deferred. This can ultimately help your business increase its cash flow.
Refinance - Come to the end of the loan's term you do have the option (if applicable/) to refinance to a traditionally amortized loan. At that point, you may even qualify for a lower interest loan with more favorable terms.
Cons
Rates - Because it is a riskier loan product, interest rates tend to be high with these kinds of loans. Usually, those who do bullet loans, have projects that are considered more volatile and that's why the less favorable terms.
Market Changes - Depending on when your maturity date is, you could have a rate hike and have to qualify all over again. Which means in the end, you could potentially refinance at an even higher rate than what you were at.
Balloon Payments - That balloon payment does tend to linger. If you near the date and are faced with the possibility of not being able to repay it, there could be monumental problems. You definitely want to make sure that you anticipate that payment and that you will, in fact, be able to make it.
Should You Take Out a Balloon Loan for Your Business?
If you need a fast infusion of a large amount of cash, then you may want to consider a bullet loan. Whether you're looking into buying land, purchasing equipment, maybe building out a facility, it's a great product for getting your funds now and allowing you to make low payments over the short term.
You absolutely need to keep that large balloon payment in mind though. Have a strategy for repaying it when the time comes. If you are unable to make that lump sum payment, you very well could lose your business. Just understand the terms going in and honestly evaluate if your business can indeed handle it.
At First Union, we love helping small businesses. We want to see your business grow and thrive. If you are in need of any advice or have questions, call today!