How Does A Bridge Loan Work: A Homebuyer’s Guide

As an investor, it is helpful to have a financial toolkit that provides both short-term and long-term options; this allows for the flexibility to adapt to the demands of various real estate deals and scenarios. For example, what would one do if they were in the process of listing one property for sale, yet have already identified a new excellent deal? The answer is simple: bridge loans. Not surprisingly, bridge loans may be just what you were looking for to bridge the gap between two independent deals.

Read on if you want to improve your own investor toolkit, and perhaps to keep yourself from asking “what is a bridge loan and how does it work” more times than you have to.

What Is A Bridge Loan In Real Estate?

A bridge loan is a product that allows a homeowner to purchase a new property before they have sold the property in which they currently live. Just as it might sound, bridge loan financing serves to fill a financial gap on an interim basis, as it can be difficult for homeowners to qualify for two mortgages at once.

Real estate bridge loans also serve as an important tool for investors. When the need to finance a new deal on a short timeline arises, investors can gain access to capital by taking out a short-term bridge loan. Before addressing the question of “how do bridge loans work,” it should be noted that the term ‘bridge loan mortgage’ is often used interchangeably with the terms ‘swing loan,’ ‘gap financing’ and ‘interim financing.’

How Does A Bridge Loan Work?

A bridge loan can come into play when a homebuyer or investor wishes to purchase a second property, even though they have not sold their existing property yet. As an example, this type of scenario may occur in a slow seller’s market, or if an investor wishes to finance a new investment project while wrapping up another. However, the challenge in these occasions is the difficulty in qualifying for two mortgages at once. Furthermore, many lenders will refuse to lend on a home equity loan if the property has already been listed on the market.

Here, the individual can take out a bridge loan as a lien against the existing property in order to finance the purchase of the secondary property. Once the original property sells, the buyer will then use the proceeds to pay off the bridge loan and qualify to apply for a new mortgage to finance the new property. Lenders will typically finance up to a certain percentage, roughly eighty percent, of the combined value of both properties. Any remaining balance on the purchase price of the secondary property will be paid in the form of a down payment.

Lasting roughly five months, and sometimes up to a year, qualifying for a bridge loan varies from lender to lender. Many lenders will underwrite the loan by evaluating the value of the deal, rather than closely examining the individual’s financial qualifications. The following sections outline additional benefits and risks associated with bridge loan financing:

When To Use A Bridge Loan

As their names lead us to believe, bridge loans are often used when homeowners want to buy a new house before they even sell their existing house. In doing so, homeowners will acquire a bridge loan to simultaneously pay down their current mortgage obligation and cover the downpayment on their next purchase. With that in mind, however, there are several scenarios in which homeowners may find themselves in that would benefit from acquiring a bridge loan. Most notably, bridge loans may be a good fit for those who:

• have found a new home in competitive seller’s markets.

• aren’t able to negotiate a home sale contingency into their impending purchase of a new house.

• can’t afford the down payment on the new home without selling their current home first

• want to purchase a new house before selling their old home.

• aren’t on schedule to close on the sale of their current home before they buy a new home.

Bridge Loan Costs

Bridge loans tend to have more “moving parts” than their traditional counterparts. In particular, bridge loans add an extra variable: the loan repayment is contingent on two properties. By nature, bridge loans help homeowners pay off an existing loan and initiate a new loan. As a result, bridge loans expose their lenders to more risk. However, the added level of risk comes at a higher price, as bridge loans usually coincide with higher rates. To mitigate some of the risk lenders take on, bridge loans typically exceed their traditional counterpart by about 2.0%. The exact rate itself will depend on the specific lender and the current market environment, but the fact remains: bridge loans are more expensive than traditional loans.

In addition to higher interest rates, borrowers will also be expected to pay all of the fees which have become synonymous with buying a home. Otherwise known as closing costs, additional fees may range from 1.5% to 3.0% of the entire loan amount and may include the following:

• Administration fee

• Appraisal fee

• Escrow fee

• Loan origination fee

• Notary fee

• Title policy fee

Types Of Bridge Loans

To be perfectly clear, there are not different types of bridge loans. Instead of lenders offering several types of bridge loans, they tend to simply extend a wide range of terms under a single bridge loan umbrella. More specifically, bridge loans are versatile and tend to vary based on three specific factors: interest rate, repayment method and loan term. Amortization schedules on bridge loans, for example, can be handled in one of several different ways. Some lenders will prefer to have their borrowers make monthly payments, but others may be more content with their borrowers making lump-sum interest payments at the end of the loan term. While the means to the end may be slightly different, the result is the same. Therefore, the type of bridge loan is irrelevant, and borrowers should pay more attention to the terms themselves.

Benefits Of Bridge Loans

The benefits of bridge loans include, but are not limited to:

• Structural Flexibility: A bridge loan can be used to completely pay off loans on an existing property, or taken out as a secondary or tertiary loan on top of existing mortgages. Offering flexibility on how it is structured, buyers can decide what proportion of the loan they would like to use on paying off existing liens, versus how much to use toward down payment purposes on a new property.

• Buy Without Restrictions: Bridge loans can empower both homebuyers and investors to purchase a second property without having to sell a primary property first. For example, an investor can finance a new deal through a bridge loan while waiting to wrap up and sell a fix-and-flip property.

• No Immediate Payments: Typically lasting a few months, and up to one year, bridge loans often allow a few months before the first payment is due. This provides buyers with a little bit of breathing room to get their finances in order.

• Remove Contingencies: When a home sale contingency is placed in a purchase agreement, a buyer is protected in the event they are unable to sell their original property first. If a seller refuses to accept, a bridge loan can help circumvent the need for such a contingency.

• Adapt To Market Shifts: There are some scenarios in which a buyer must purchase a new home, yet may encounter difficulty selling their original property immediately. Examples may include a work-related relocation, or an unexpected lull in the market. A bridge loan offers a solution for buyers who need to buy time to sell an existing property.

Risks Of Bridge Loans

The drawbacks of bridge loans include, but are not limited to:

• High Interest Rates: A common attribute for short-term financing options, the interest rate for a bridge loan is typically two percentage points higher than an average mortgage loan. The lender may increase the rate based on the level of perceived risk.

• High Closing Costs: Lenders will often inflate the closing costs for a property financed with a bridge loan, as they will assume that the buyer presents a strong desire to purchase the property.

• Prepayment Penalties: Because bridge loans accrue interest at a higher rate, borrowers are understandably incentivized to pay off the loan as soon as possible. However, most loans have a prepayment penalty written into contract. Those who do not want to pay a penalty should plan to pay off the loan at its maturity.

• Financial Management: Managing liens on two properties and accruing bridge loan interest at once, may cause stress for those who do not have a clear financial plan.

• Property Collateral: A bridge loan works by placing a lien on the borrower’s existing property. There is the risk of things going awry, such as the property not selling, or the buyer’s financing falling through. If anything goes wrong, the borrowers risk being led to foreclosure proceedings.

Alternatives To Bridge Loans

Bridge loans are a great source of capital for those looking to buy a home before their current home sells. That said, bridge loans aren’t the only source of capital for those with specific time constraints. Prospective buyers are granted access to several alternatives that offer similar benefits, not the least of which include:

• Home Equity Line of Credit (HELOC): A home equity line of credit works a lot like a second mortgage. In allowing homeowners to take out a line of credit against the equity in their current home, HELOCs grant homeowners access to their own equity. Borrowers can draw on the equity on a revolving basis for up to 20 years. Since HELOCs have an extend repayment period they tend to coincide with a lower risk of default, which means interest rates will most likely be lower than most bridge loans.

• Home Equity Loans: Not unlike HELOCs, home equity loans allow borrowers to tap into the equity of their existing home. Similarly, home equity loans will coincide with lower interest rates than bridge loan because of their risk-averse nature. However, unlike HELOCs, home equity loans will require borrowers to take a lump-sum payment. Since home equity loans don’t allow borrowers to take the money as they need it, they are better left for those who know exactly how much they need to borrow.

• 80-10-10 Loan: As their names suggest 80-10-10 loans give borrowers access to 80% of the original purchase price. Subsequently, 80-10-10 loans will add an additional loan that covers 10% of the original purchase price. Combined, the two loans will cover 90% of the home’s purchase price. The remaining 10% will need to be covered by the borrower’s own money (the down payment). The concept behind the 80-10-10 loan is to simultaneously give borrowers enough money to buy a new home and use the proceeds from their sale to pay off the new loan.

• Personal Loan: Buyers in need of timely cash may always resort to a personal loan. However, personal loans tend to have a strict approval process. Personal loans will require borrowers to have a strong credit history, strong proof of employment, a pristine track record of timely payments, and an acceptable debt-to-income ratio. It is worth noting that personal loans need to be secured by personal assets, and terms and conditions will vary from lender to lender.

Summary

In real estate, bridge loans are short-term loan products that facilitate the purchase of a secondary property when the borrower has not yet sold their primary property. Because of stringent mortgage loan qualifications, it can be challenging for individuals to obtain two mortgages at once. Bridge loans offer a solution to this challenge by allowing buyers to take out a lien against an existing property in order to finance the second property on an interim basis. Bridge loan borrowers enjoy benefits such as freedom and flexibility, while facing downsides such as inflated interest rates and closing costs. When committing to any type of financial commitment, both homebuyers and investors alike should carefully weigh any potential pitfalls against the benefits.

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