Potential borrowers should understand what a bullet loan is, when this type of financing might be used, how it works, and the risks associated with bullet loans before borrowing. Here’s what you need to know to answer these questions.
Definition and Examples of Bullet Loans
Bullet loans are a type of financing that provides borrowers with low or no monthly payments for a period of time. During that time, interest still accrues on the loan. At the end of a designated repayment period, the borrower must pay off the entire loan balance. Bullet loans usually have a short repayment timeline—usually just a few years. Often, the remaining balance due is for the full amount borrowed, plus any accrued interest. This can be a very large lump sum. For example, say a borrower took out a $200,000 bullet loan with a 15-year repayment term that required only interest payments. At the end of 15 years, the borrower would be required to pay back the entire $200,000 in principal in one lump sum. A borrower might take out a bullet loan to pay off a construction loan after building a new home, with the goal of securing a permanent mortgage.
How Do Bullet Loans Work?
With many types of loans, borrowers make principal and interest payments throughout the loan repayment period. These are calculated to ensure the loan is paid in full by its maturity date. A bullet loan is different. The borrower may make no payments at all, or they may make very small payments for most of the repayment period. This can make the loan affordable upfront. But when the loan matures, the borrower must pay off the entire amount due. Borrowers repay the full balance all at one time, instead of over time. Often, borrowers will secure a new, refinanced loan to pay off the bullet loan. If not, they may have to come up with tens or even hundreds of thousands of dollars in cash.
Alternatives to Bullet Loans
Alternatives to balloon loans include:
Fixed-rate loans: With this loan, the most common option that homebuyers choose, the interest rate is fixed for the life of the loan and monthly payments remain the same for the full payoff period. There is no large lump-sum payment due. And the amount of each payment is calculated so that the loan is paid off in full at the end of the payoff term. Adjustable-rate loans: This type of loan comes with a variable rate tied to a financial index. The rate can adjust at periodic intervals. Each monthly payment is still calculated so that the loan is paid in full at the end of the payoff term, with no lump-sum payment due. However, the amount of each monthly payment can vary depending on the current interest rate after the loan adjusts.
Advantages and Disadvantages of Bullet Loans
The big advantage of a bullet loan is that you can borrow money for months or even years without having to make payments on it. But the serious disadvantage is that a large lump-sum payment is due after a relatively short time. If you make no payments at all until the bullet payment is due, interest also can accrue on the loan during that time. The final balance you may need to pay off with your lump sum could be larger than the amount borrowed.
