What is a bridge loan?
Bridge loans offer a lending option for borrowers who need to make a large purchase but lack the cash on hand to complete the sale.
A small business owner, for example, might need to take out a loan for an expensive piece of machinery in order to conduct their business, but can’t afford to cover the costs of financing on their own. A bridge loan would provide them with immediate funding needed to secure the asset, while the company seeks a source of additional financing.
Also known as bridge financing, this short-term loan is a popular option for motivated businesses and individuals looking to move quickly and acquire critical assets that might not stay on the market for long.
Bridge loans & homebuying
Let’s say you land a new job and need to move quickly. The cost of a down payment, closing costs, real estate agent fees and other expenses can be far out of reach for someone who wasn’t expecting to move.
In addition, you might sell your home and have trouble closing on a second. Or, you could close on a second home early and be stuck paying two mortgages for several months.
Bridge loans can help avoid these issues and help cover the many expenses that can arise when you’re in between houses. By providing immediate financing, you would be able to cover the costs of moving without having to pay for two mortgages at once.
In order to secure this type of loan, you’ll need to put up an existing asset for collateral. If you’re using a bridge loan for a real estate purchase, the equity you’ve gained on your current home can be used to satisfy this requirement. Lenders will typically require at least 20% equity in the property to approve a bridge loan.
Depending on your lender, the fees, terms and conditions of your bridge loan can vary. Some may come with a monthly payment schedule, while others can take payment in a lump sum. Be sure to meet with multiple lenders to find the bridge loan agreement that works best for your situation.
No matter what the terms are, having a bridge loan can make the moving process immensely easier, thanks to your ability to present a contingency-free offer.
A contingency-free offer assures your seller that you can buy the house without having to sell your current home. In a “seller’s market” where multiple buyers are vying for the same property, a seller might be more inclined to accept an offer without contingencies, given that the sale won’t depend on your house being sold.
Minimizing complications like this is one of the major benefits of a bridge loan. “Bridging the gap” while buying and selling a home at the same time makes the process easier, but the convenience will come with a price.
Bridge loans and businesses
Companies that need to cover operating costs while waiting for a larger influx of funding might consider taking out a bridge loan. If the owners are expecting the next round of financing to close in a few months, but will be strapped for cash in the meantime, bridge loans might present a convenient option.
As is the case with all bridge loans, the lender would require a piece of collateral, such as equity in the business, in order to approve the loan. The financing received can be used to cover payroll, utilities, rent or any other approved business expenses until the anticipated cash flow comes through.
Risks of a bridge loan
Bridge loans might seem like a good way to secure some cash flow in the short term, but they do come with a few drawbacks you should be aware of before you apply:
- Higher interest & fees
- Shorter repayment terms
Bridge loans are typically more expensive than longer-term financing, such as a personal loan. While bridge loans can help cover a gap in funding, they do typically come with a higher cost for the borrower.
The short-term nature of bridge loans means lenders will not make as much in processing and interest as they would with a longer-term loan, such as a mortgage. To make up for this lower return, lenders will usually charge additional interest and fees.
Bridge loans can be folded into your regular mortgage payments, which will increase the overall amount you pay each month. According to Forbes.com, this type of financing usually comes with an interest rate between 8.5% and 10.5%. The amount attached to your loan specifically will depend on your financial background and which lender you choose.
Lenders will also seek additional security through a borrower’s assets. The buyer’s current home is usually put up as collateral in order to secure the bridge loan. The lender will retain partial ownership of the property until it is sold and the remainder of the loan is repaid.
Other assets such as vehicles or bank accounts can also be used as bridge-loan collateral.
Short repayment terms
Depending on the terms and conditions set by your lender, your bridge loan might feature a very short amortization schedule. Being saddled with additional debt while taking on a mortgage can make some borrowers anxious, so be sure the pros of taking out a bridge loan outweigh the cons for your specific situation.
When are bridge loans a good idea?
Sudden life changes like a new job could mean an unexpected need to relocate. Homebuyers in this situation may not have the savings on hand to completely cover the costs of closing on a new loan. Bridge loans can help cover this gap and ensure buyers will have the funds to bid on a new house.
A prospective buyer might also consider a bridge loan to secure an offer in a competitive market. Making up the gap in funding means the borrower will be able to present the seller with an offer that will move quickly. Other offers might come with a contingency that the sale will go through if the buyer cannot sell their current home. Securing a bridge loan will allow borrowers to present a contingency-free offer, meaning the sale will not depend on external factors and is much more likely to proceed without delay.
Sellers and their real estate agents will always prefer a contingency-free offer in a situation when multiple bidders are vying for the same property. In this type of seller’s market, bidders with a more expedient and less risky proposal will always stand out.
Bridge loans provide a path to homeownership for buyers on a short-term schedule. Loans like these help cover some costs when buying a home, but come at an additional expense for the buyer.
Learn what other loan options lenders can provide to help buyers secure funding for a home.