Pros and Cons of a Bridge Loan You Should Consider
Getting a bridge loan might be a terrific way to get the money you need to make a real estate investment. Bridge loans are a type of short-term loan with repayment terms ranging from a couple of weeks to a few years. A typical bridge loan, however, is only suitable for a period of six to twelve months. Short-term financing is made available through this sort of loan, allowing borrowers to quickly close on an investment property or buy another property while waiting to sell an existing one.
Many homeowners find themselves in a bind when buying a new house while selling an old one. A bridge loan is a short-term loan used to bridge the gap between two other types of loans. A bridge loan could be your best option if you can’t get financing from a traditional lender or need to close a deal quickly. In this article, we’ll examine the pros and cons of a bridge loan in detail.
Bridge loans – How do they work?
Bridge loans are short-term loans intended to cover expenses until more permanent financing can be obtained or existing debts are settled. Borrowers can keep up with their bills thanks to this quick cash infusion. Short-term loans, sometimes known as “bridge loans,” typically carry high-interest rates and require the borrower to secure the loan with valuable collateral, like real estate or inventory.
How a Bridge Loan Works
Bridge loans, also known as interim financing, gap financing, or swing loans, are used when permanent finance is required but not yet available. Individuals and businesses use bridge loans, which can be tailored to meet borrowers’ needs in various scenarios.
It is possible to use a bridge loan to buy a new house before the sale of the current one has closed. To help with the down payment on a new house while their current one sells, borrowers can tap into the equity they’ve built up. By providing the borrower with a bridge loan, the homeowner can buy some time and, in many cases, find some peace of mind. Unlike other forms of lending, such as a home equity line of credit (HELOC), the interest rates on payday loans tend to be significantly higher.
Real estate bridge loans are rarely provided to borrowers who don’t have stellar credit and a low debt-to-income (DTI) ratio. While waiting for the sale of the first home, a buyer can gain financial flexibility with a “bridge loan,” which combines the mortgage payments on the second property with the first. However, most lenders will only provide real estate bridge loans of 80% of the total value of the two properties so the borrower will need substantial equity in the first property or substantial cash reserves.
Businesses use bridge loans as a short-term funding source while securing more permanent funding sources. Let’s say, a company is seeking equity funding, and that round is scheduled to close in six months. Until the investment round closes, it may use a bridge loan as a working capital source to pay for salaries, rent, utilities, and inventory.
When to Use a Bridge Loan
If you plan on buying a new home before selling your current one, start with understanding the pros and cons of a bridge loan. One option for a borrower with an existing mortgage is to utilize a portion of their bridge loan to pay off their existing mortgage while utilizing the remaining funds as a down payment on their next house. A homeowner can utilize a bridge loan in the same way they would use a second mortgage to pay for the down payment on a new home.
You could benefit from a bridge loan if:
- You have settled on a new residence and found yourself in a fast-moving real estate market
- Attempting to buy a home contingent on the sale of your current residence, but the seller won’t accept such an offer
- You need to sell your current home to cover the required down payment on the new property.
- Wish to sell your present house and close on a new one simultaneously
- Don’t have a closing date set for the sale of your present home that conflicts with the purchase of your new home
Enterprises can employ bridge loans to capitalize on timely real estate possibilities or cover unexpected costs. Hard money lenders, who provide loans secured by your property, and online alternative lenders are common sources for these kinds of financing for businesses. The interest rates on these loans are significantly higher than those on other types of loans for businesses.
Bridge loans are often used for, and not limited to, the following in the business world:
- Keeping the lights on while waiting for permanent funding.
- Obtaining the money to make a real estate purchase quickly
- exploiting time-sensitive sales of goods and services
Bridge Loans – Main Types
Closed Bridging Loan
Both parties agree on the length of time a closed bridging loan will be accessible before it must be repaid. Since it gives the lender more assurance that they will be repaid, it is more likely to be accepted. It has more favorable terms than a traditional bridging loan.
Open Bridging Loan
An open bridge loan doesn’t have a set payment date or way to pay it back, and the terms of the loan aren’t set until after the initial inquiry. Most bridge businesses will deduct interest from the advance on a loan as a precautionary measure before releasing the funds. Borrowers who don’t know when their permanent financing will be ready often opt for an open bridging loan. A higher interest rate is attached to this form of bridging loan because of the lender’s uncertainty in receiving repayment.
First Charge Bridging Loan
The lender receives priority lien status on the property when a first charge bridging loan is taken out. The lender with the first charge on the bridge loan will be paid back before any other creditors in the event of a default. The minimal level of underwriting risk means that the loan comes with cheaper interest rates than second-charge bridging loans.
Second Charge Bridging Loan
Lenders who provide the second-charge bridging loans take priority after any preexisting first-lien holders. Short-term loans have a fixed repayment duration of less than a year. They are associated with a greater probability of default and, consequently, command a higher rate of interest. Second-charge loan lenders wait to collect from borrowers until all obligations to the first-charge bridging loan lender have been satisfied. In contrast, a second-charge bridging loan gives the lender the same repossession rights as the first-charge lender.
Pros and Cons of Bridge Loans
Provides flexibility when shopping for real estate
Most sellers will insist that buyers wait until they’ve sold their current home before signing contracts to purchase another. The seller is concerned that if the buyer doesn’t have enough money for a down payment, the sale won’t go through since there won’t be enough money to pay for the property. A bridge loan can alleviate this difficulty because its expense equals the down payment.
You may not need to go through a credit check to obtain a bridge loan.
The application process for a bridge loan may differ from other types of loans in this space. Certain loan providers need to see tax returns, a manageable debt-to-income ratio, and a good credit score in these instances, but this is not always the case. Some people believe that if you were approved for a home loan, you would also be approved for a bridge loan.
You won’t need to worry about making a monthly payment.
Repayment on a bridge loan typically does not begin until a few months after the loan is obtained. This alleviates much stress for homeowners who are relocating because they won’t have to worry about juggling two bills at once. In other words, you can sell the house and pay off the mortgage in full well before any payments are due. If you can pay back the loan in full immediately, most lenders won’t charge you any interest for the period you have it.
Generally faster application, underwriting, and funding process than traditional loans
Bridge loans are much quicker to get approved for than other types of loans. This means you may move into your new place as soon as you find a buyer for your old one, without waiting for the best offer. You can skip the hassle of finding temporary housing elsewhere or finding a place to temporarily keep your possessions by moving in straight away.
A bridge loan helps you secure a property in a tight market.
In competitive real estate markets, sellers might attract buyers without accepting contingencies. You can miss out on the house of your dreams if you wait for your current home to sell before looking for a new one. You can make a firm offer without worrying about coming up with a down payment on your next home loan if you have access to a bridge loan to assist you in getting there.
Most sellers would want a fast transaction. If you don’t need to wait for any more contingencies, lenders may be more inclined to give you a better deal if you have the cash on hand to arrange financing immediately. Although the closing costs and interest on the loan will cut into the proceeds from selling your old home, many people find the process worthwhile.
Higher interest rates than some other types of loans, like HELOCs
When you use a bridge loan to finance your next home, you’ll have to pay a higher interest rate and annual percentage rate. The costs associated with this choice are substantial. The appraisal and any other loan-related closing costs are your responsibility. MarketWatch reports that when you factor in the appraisal, administration, and title costs, a $10,000 loan will cost you around $2,200. Some lenders employ a variable annual percentage rate on the loan product as an additional risk mitigation strategy, and the interest rate is often double that of a mortgage.
You have LTV limits to consider with a bridge loan.
If you’re considering a bridge loan to acquire real estate, it’s essential to realize that the maximum loan-to-value (LTV) ratio is 80%. To put it another way, you need at least 20% equity in your current home to sell and come up with the money to buy the house you want. Even if the lender determines that your credit and income are sufficient to cover payments on two mortgages for some time, you will not be approved for the loan unless you have sufficient equity in your primary residence to cover both mortgages.
Also, if a home’s market value is low, it can be difficult for purchasers to finance a purchase. Having the same equity in a home worth $50,000 and a home worth $300,000 is significantly different.
Bridge loans are often structured with the property as collateral.
If you fail to repay a bridge loan, the lender may seize the property you put up as collateral. If you can’t pay off this debt, your financial situation will only worsen, and you may lose the right to sell your first home. A lender may also require you to take out your subsequent mortgage with them if they have this option, preventing you from shopping around for the best interest rate.
This disadvantage can arise even if all initial loan payments have been made on time if the borrower cannot make the final balloon payment.
You have limited long-term options with a bridge loan.
Bridge loans often have a short repayment period of 12 months or less. What happens if your home doesn’t sell? You’re still responsible for the full payment. There is a cap on how long a borrower can get a deferral or how long they can pay interest alone. Nearly all of them require a lump sum, or “balloon payment,” at the end of the loan term.
There is a better lending package if you need more than a year to manage your money throughout a housing relocation. It would help if you looked for one that doesn’t have excessively high fees or a large final payment.
The Bottom Line
Weighing the bridge loan pros and cons reveals that they represent a great option to pursue in some circumstances. Costs should be weighed against how quickly you anticipate selling your current home. You probably don’t need this product if you have enough saved for the next down payment and can afford two mortgages for a few months.
To purchase your ideal home, a bridge loan may be a viable option if you need a little amount of additional funding and have sufficient equity. Contact our experienced team of experts to be navigated the hard money loan process via FB, IG, or WhatsApp, or call at 323-448-3956.