If you’re looking for ways to finance your small business with a quick infusion of cash, one option to consider is a bullet loan. Unlike other types of business loans, their payment plan lets you delay repayment of the principal until the end of your term. In some cases, you can even delay paying interest as well.
They can be an attractive option if your business needs cash now, but by definition, carry some financial risks that can increase your future debt.
To help mitigate this risk while still taking advantage of the benefits of this powerful financing tool, we’ll tell you what you need to know about bullet loans, how they work, when it makes sense to use them and how to avoid potential problems.
Bullet Loan Definition: What Is It?
A bullet loan (sometimes called an interest-only or balloon loan) is distinguished from other types of financing products by the final payment requirement when it reaches maturity. With traditional amortized loans, you follow a schedule of regular payments against principal and interest until they’re fully repaid at the end of your term.
With a bullet plan, repayment for your loan’s principal is delayed until the end of the term, when you must make a lump sum payment covering any unpaid amount. This final principal installment is also known as a balloon payment because of its inflated size. Structuring repayment this way lowers monthly payments, one of the biggest reasons your business might turn to bullet financing.
When you apply for a bullet loan, you get evaluated through an underwriting process just as you would for a regularly-amortized option. They can be secured or unsecured. If you qualify, you’ll be approved for a maximum principal amount.
Due to the high, deferred payments, these financial options are generally considered for short-term lending situations. Common usage is for commercial land, making them popular with real estate developers.
How Do Bullet Loans Work?
If you receive a bullet loan, it can generally be structured in one of two ways:
- Interest-only installments until your final bullet debt payment for the principal
- No payments until loan maturity at which time you’ll pay off the remaining balance (principal + interest)
With the majority of bullet loans, you pay accruing interest throughout your term, just as you would with other financing products. However, with some plans, you delay repaying both principal and interest until the maturity date.. This repayment plan, known as a full-lump-sum bullet loan, increases the amount of interest that accumulates over your term, resulting in a significantly higher balloon payment.
Common Bullet Loan Terms
Since the repayment of debt is unique, bullet loans have distinct terms.
Repayment length is short-term and usually does not exceed 5 years. However, interest can be based on an amortization calculation of up to three times the length of maturity, raising the total you’ll pay.
Payments are based on the terms of your loan and which type of structure you’re under. They’ll be set monthly, annually or deferred to a single bullet payment. Calculations are made based on the assumption that you won’t be pre-paying any of the principal balance. Doing so increases the total interest that accrues because the rate is applied to a constant, high number.
What Happens at the End of a Bullet Loan?
Because the balloon payments are so high, borrowers who use bullet loans commonly refinance them at the end of the term. The initial principal enables the borrower to obtain access to the capital they need to finance their business. They can then take advantage of the low interest-only payments and devote their finances to their business until the maturity date. This puts them in a position to refinance at the end of the term.
Some bullet loans have an interest-reset option at the end of their term. This resets the interest rate based on what you’d currently qualify for, thus recalculating payments based on the new terms. For those that do not have an interest reset option, borrowers must either refinance or be forced to pay the full principal at one time.
Examples of Bullet Loans
Bullet loans are used in several types of situations, but they’re particularly favored by real estate developers.
For instance, a real estate development company may use a bullet loan to purchase an undeveloped tract of land which has low collateral value. They can then use the funding to develop the land, erecting property that gives it a significantly higher collateral value. The developed property can then be used as collateral to refinance at the end of the term. This strategy can be used to develop anything from a single tract of land to an entire subdivision.
Similarly, a business might take out a bullet loan to finance the construction of a new facility. Once the facility has been completed, the finished building can be used as collateral to refinance.
A less common example is equipment financing. You could use the funding to purchase new equipment, and then use that equipment to generate revenue which can be put towards the balloon payment or putting the company in a position to refinance.
The Pros and Cons of Bullet Payment Plans
Bullet loans offer attractive advantages, but also some big risks over traditional financing options. Finding the right balance that works for you will give you insight into whether they’re the right choice for your small business.
Due to their shorter terms and risky nature, bullet loans can be easier to qualify for than those with more favorability to the borrower, such as business term loans.
Lower Initial Payments
Their deferred principal payment feature makes them useful for short-term financing when you aren’t expecting an immediate increase in cash flow. This can allow you to take out a loan you could not otherwise afford.
Choice to Refinance
In certain situations, you can refinance to a loan with normal amortization at the end of your term. This could work to your advantage if you used the original bullet loan to give you the extra capital or collateral to qualify for a new, low-interest option.
With more relaxed qualification requirements come higher interest rates. Due to the volatility of a lot of the borrowers and their projects, lenders have a higher risk and must make it worth their investment. Your lower payments also mean less cash flow to the lender, so they offset that by hiking up rates.
If interest rates rise significantly before your maturity date, you may have to go through the qualifying process all over again to refinance. This can be time-consuming, and it may mean you end up refinancing at a higher interest rate than before.
Large Balloon Payments
The most serious risk bullet loans carry is not being able to repay or refinance the lump sum at the end of the term. This makes it imperative that you’re sure that you can fully repay or refinance your debt before taking out this type of loan.
Is a Bullet Loan Right for Your Small Business?
A bullet loan plan can be an effective way to infuse your business with a large amount of available cash. This can be useful for purposes such as constructing or buying a new facility, as well as making a purchase that can bring in large amounts of revenue that you don’t currently have.
However, it places a burden on you to repay or refinance a large amount at the end of your repayment term. This carries the risk of leaving you unable to pay off your debt, potentially putting you and your small business in jeopardy. Make sure you’re confident in your ability to meet your repayment obligations before applying. But, if you possess the means, a bullet-repayment plan can be a great way to get the cash your business needs now.