A bullet loan is a loan in which the borrower pays the original amount in one large sum at the end. We refer to the original loan amount as the principal. Some bullet loans may involve interest only payments during the term, with the principal due at the end.
The term balloon loan means the same as bullet loan.
A bullet loan differs from other types of lending. In most cases, borrowers’ installments throughout the term include principal and interest payments.
We also refer to the large payment at the end of a bullet loan as a ‘balloon payment.’
“A bullet loan requires the entire payment of the principal at the end of the loan term, instead of in regular installments.”
Imagine you take out a $10,000 loan that you must repay 12 months. This loan has an annual interest rate of 7%. If this were a pure bullet loan, you would make one big payment at the end. In other words, you would pay the $1,000 principal plus $70 in interest in one payment at the end.
Advantages of a bullet loan
Bullet loans are great for companies that have a serious short-term cash flow problems. If they do not have to pay anything back immediately, it helps solve their cash flow problem.
However, as the payment is a ‘balloon’ one, borrowers risks defaulting at the end. In other words, they might not be able to make the large payment at the end.
A bullet loan is ideal for people who are short of money but expect to receive money soon. For example, if you are expecting an inheritance, this type of loan may suit you. Also, people expecting a settlement payment may find this type of loan ideal.
Experts say this type of loan is highly risky. In fact, many financial advisors warn that in some cases they are predatory.
Lenders first created bullet loans to help firms finance long-term investments, growth, or to develop new business.
They became popular as mortgages. We refer to mortgages with a large payment at the end as balloon mortgages. Most balloon mortgages have shorter terms than other fixed-interest mortgages.
When property prices fall
Using a bullet loan to buy a home works well for people who cannot afford to pay high installments. However, they only work if property prices rise.
At the end of the term, they can sell the property, which should be worth much more, or refinance.
When the 2007/8 global financial crisis hit and property prices plummeted, many borrowers were stuck. For example, borrowers with bullet loans had properties that had dropped in price. These people could not sell their homes and use the profit to meet the balloon payment.
Video – What is a balloon?
Some bullet loans have elements of conventional loans. In this video, the speaker explains how lenders ‘push’ 30% of the principal to the end of the term. In other words, the borrower’s final ‘balloon’ payment is thirty percent of the principal.