What Is A Bridge Loan And How Do They Work?

A bridge loan is often used in real estate transactions to provide cash flow during a transitional period, such as while moving from a current residence into a new home. Homeowners can use these short-term loans, which can help quickly put more cash in their pockets, to finance a new home or pay off an existing debt obligation. However, like any form of financing, bridge loans come with their own benefits and drawbacks. Let’s take a closer look at what bridge loans are and how they work.

Bridge Loans, Defined

A bridge loan is a form of short-term financing that can serve as a source of funding and capital until a person or company secures permanent financing or removes an existing debt obligation. Bridge loans (also known as swing loans) are typically short-term in nature, lasting on average from 6 months up to 1 year, and are often used in real estate transactions. They can be used as a means through which to finance the purchase of a new home before selling your existing residence.

As you might imagine, most home sellers would ideally prefer to wait until their house is under contract before placing an offer on a new one and using money from the sale of their existing property to help finance a new real estate acquisition. Should you be unable to offload your property and facilitate such a sales transaction, bridge financing can provide you with the funds needed to move forward on purchasing a new property regardless. Put simply, bridge loans give you access to additional money with which to purchase a piece of real estate by allowing you to tap into added funds, or any equity that you hold in your current home prior to its actual sale.

It’s not uncommon for homeowners looking to make a sudden transition (for example, having to quickly transfer to another location for work-related purposes) to need a way to bridge the gap between homes. A bridge loan can help you finance your way through this transitory time period. In addition – especially if you’re trying to shop for a new home in a hot market – it can also help you avoid having to make sale-contingent purchase offers on new properties. (Many buyers tend to shy away from doing this, as these offers provide the option to back out of the contract if your current home doesn’t sell.) However, although it’s secured with your current home as a form of collateral, a bridge loan isn’t designed to replace long-term financing like a traditional mortgage, or other types of home loans, and is meant to be repaid within roughly 1 – 3 years’ time. Because of this, a bridge loan is considered a type of non-mortgage or specialty financing rather than a traditional mortgage.

How Does A Bridge Loan Work?

Bridge loans are typically used by sellers who find themselves in a tight spot or needing to make a sudden change of locale. At the same time, bridge loans’ terms, conditions and fees can vary greatly between individual transactions and lenders. Some of these financing vehicles are designed to pay off your first mortgage at the time that the bridge loan closes, while others add and pile new debt onto the total overall amounts owed. Costs can also vary considerably between lenders, and bridge loans can differ greatly in payment structure. For example, some may require you to make monthly payments, while others may be structured to require a mix of upfront and/or end-term or lump sum payment charges.

Common reasons to seek out a residential bridge loan include:

• Inability to afford a down payment without first selling your current house
• A pressing need to quickly secure a new home
• The closing date for a new purchase is scheduled after the closing date for the sale of your home
• A preference to secure a new property before listing your current residence
• Sellers in your desired area aren’t comfortable with contingent purchase offers

In general, two main options are available for those seeking a bridge loan:

• To use the bridge loan as a second mortgage to put toward the down payment on their new home until they can sell their current home
• To take out one large loan to pay off the mortgage on their old home and put the remaining money borrowed toward the down payment on their new residence

Similarly, bridge loans tend to:

• Run for 6-month or year-long terms
• Be secured using the borrower’s current home as a form of collateral
• Only be issued by lenders with whom you agree to finance your new mortgage as well
• Vary in amounts of interest charged, with charges typically hovering slightly above the prime rate

Note that applying for a bridge loan works similarly to applying for a conventional mortgage. Your loan officer will look at numerous factors when considering applications including your credit score, credit history and debt-to-income ratio (DTI). What’s more, the majority of institutions that issue bridge loans will allow applications to borrow a maximum of up to 80% of their loan-to-value ratio (LTV). In other words, you’ll typically need a minimum of 20% equity in your current home in order to qualify for a bridge loan package, as well as to meet additional financial qualifications outlined here.

Common Home Bridge Loan Rates

Interest rates associated with bridge loans are generally higher than with conventional loans – including charges that tend to range up to roughly 2% above prime rate. As with traditional mortgages, bridge loans also incur closing costs (which can skew up to a few thousand dollars in expenses, plus a certain percent of the loan’s value) and origination fees to boot. You may additionally be required to pay for an appraisal as well.

Be advised, though: As protections for buyers are often limited in the event that the sale of their current home falls through, it’s important to read the terms and conditions associated with any bridge loan offer. Because bridge loans are secured with your existing property, it can be foreclosed upon by a lender in the event payments are not met. Noting this, you’ll want to carefully consider just how long that you can afford to go without financial relief in the event that a sale stalls, and make a point to avoid overextending yourself on any amounts borrowed. Likewise, you’ll also find that it pays to do extensive research into the current real estate market and how long homes take to sell in your area.

Pros And Cons Of Bridge Loans

As with all forms of lending and financing, there are advantages and disadvantages associated with taking out a bridge loan. Let’s consider the upsides and downsides inherent to this form of borrowing:

Pros

• A bridge loan offers you the opportunity to buy a new house before you’ve sold your current home.
• You can make an offer on a new home without having to implement a sale contingency.
• It also provides additional funds in the event of a sudden or time-sensitive transition.
• It presents a helpful short-term solution for financing your way through periods of uncertainty.
• There is often the prospect of no monthly payments for the first few months.
• There’s potential for interest-only payments, or payments that are deferred until you sell.

Cons

• Bridge loans come with higher interest rates and APR.
• Most lenders require a homeowner to have at least 20% home equity built up before they’ll extend a bridge loan offer.
• Many financial institutions will only extend a bridge loan if you also use them to obtain your new mortgage.
• You may own two houses for a time – and managing two mortgages at once can be stressful.
• Trouble selling your property can lead to future issues, or – in a worst-case scenario – even foreclosure.

Bridge loans can be obtained from many lenders, including banks, credit unions and other financial institutions. However, it’s most common for your current mortgage provider to be the originating source for these programs. If you’re interested in pursuing a bridge loan, your lender should be your first port of call.

Pro tip: As you go about looking for a financing partner, be wary of lenders offering quick access to capital, who may charge exorbitant rates for their services, and boast less of a proven track record in terms of strong performance or customer service.