Short term loans are commonly used to generate cash flow during the transitional period to meet financial obligations till the time permanent financing is secured. Bridge loan is also a short term loan which is commonly used in the real estate sector to invest in properties or pay off mortgages before a source of financing is secured.
What is Bridge Loan?
Bridge Loan, also known as gap loan or swing loan, makes finance available when it is needed but not forthcoming from any other source. Property owners commonly use bridge loan to purchase new properties before they sell their existing properties. Thus, bridge loan acts a source of quick funds to complete the purchase before finances are obtained by selling the current property. Bridge loan can be used to make the down payment and pay the closing cost on the new home. It can also be used clear the mortgage on the current home besides making the down payment for the new home.
Working of Bridge Loan
Bridge loans usually have a repayment term of 6-12 months. The short repayment term is enough because the borrower is most likely to repay the loan from the proceeds from the sale of the first home during this period. The lender can also require interest payments on a monthly basis and a lump sum or balloon payment of the principal amount at the end of the period.
Bridge loans depend upon the equity of the property currently held by the buyer. Equity is the difference between the current value of the property and the current mortgage on the property. For instance, if the market value of a property and the mortgage balance on it is USD 500,000 and USD 200,000 respectively, then the equity held by the owner is 300,000. Lenders of bridge loans offer the difference between the current loan balance and up to 80% of the current property’s value.
Bridge loans are offered for primary residences only. This means both the existing and new property must be the principal home of the borrower. Rental properties, hotels and other commercial properties do not qualify for bridge loans.
Lenders evaluate bridge loan applications based on the loan-to-value (LTV) ratio, calculated by dividing the mortgage amount by the property’s appraised value. Typically, lenders require a maximum LTV of 70%. Therefore, maintaining a minimum of 30% equity in the current property is essential for eligibility. For further insights into bridge loan requirements, visit businessprofitdaily.com.
| Aspect | Pros | Cons |
|---|---|---|
| Speed | – Quick access to funds for time-sensitive needs. | – Limited time frame; must be repaid within a short period. |
| Flexibility | – Can be used for various purposes such as home buying or business transactions. | – Higher interest rates compared to traditional loans. |
| Ease of Qualification | – Easier to qualify for than long-term financing. | – Stricter eligibility criteria compared to some other short-term options. |
| Bridge to Permanent Financing | – Can serve as a bridge between the sale of one property and the purchase of another. | – Potential difficulty in securing permanent financing. |
| Customization | – Terms may be negotiable to some extent. | – Terms can be less favorable than other types of loans. |
| Risk | – Allows for leveraging existing assets for quick capital. | – Higher risk due to short-term nature and potentially volatile interest rates. |
| Applicability | – Useful in real estate transactions and other situations requiring immediate funds. | – Not suitable for long-term financing needs; temporary solution. |
Pros of Bridge Loan
Bridge loan eliminates the need to depend upon selling the current property first to purchase a new property. As a result, you are able to make a contingency-free offer on the property you intend to purchase. Contingency-free offers are quite attractive for sellers which helps in overcoming competition from other buyers.
It is easy to make quick offers at the earliest opportunities to purchase lucrative properties. This is because bridge loan removes the dependency on the sale of the current home to purchase another home.
Bridge loan is useful in case you need to relocate to a new place at short notice and there is no time to sell your current home. The funds obtained from the bridge loan helps you in purchasing a home at the new place, thereby saving rental expenses.
In case the closing time to purchase a new home is much earlier than the closing date for the sale of your current home, the bridge loan enables you to buy the new property easily. You are able to close the deal on the new home first and then focus on selling your existing home.
Even though you have enough equity on your current home to pay 20% down payment on your new home, you are not able to do so because your current home is yet to be sold. Thus, you are required to pay private mortgage insurance on the new loan. With a bridge loan, you have the funds at hand to pay 20% down payment and avoid private mortgage insurance.
Depending upon the lender, repayments for the bridge loan can be deferred till you close the sales deal for your current home or pay only the interest till you are able to sell your current home.
Bridge loan allows you to purchase and move into your new home before selling your existing home. Conversely, you are not required to sell your new home and move before the deal for your new home is closed.
Since bridge loan can be used to make the down payment on your new home, there is no need to use the profits earned from the sale of your existing home in paying the same.
Cons of Bridge Loan
Bridge loans carry much higher interest rates as compared to conventional loans because the repayment terms are very short. The interest rates can range between 8.5-10.5% depending upon several factors. Moreover, the interest rates can also increase over the loan period.
The short repayment term of just 6-12 months can be a source of pressure for the borrower. If you are not able to sell your current home within this period, you end up with two mortgages, one on your new home and the bridge loan. In case you still have mortgage left on your current home, the number of mortgages can rise to three.
The closing fees to pay becomes double because you have to pay the closing fees for both the bridge loan and the loan on the new home. There are other charges associated with bridge loan as well which increase the cost.
Holding 30% equity on your current home is a basic requirement to qualify for bridge loan. Moreover, you need to meet the credit requirements which vary from one lender to another.
There are not many lenders of bridge loans in the market.
Conclusion
Bridge loan is a highly suitable way to bridge the gap between two financial transactions. However, you should opt for this loan only if you are sure that your current home will be sold within weeks to few months. Having access to extra funds to make the repayments in case the sale of your current home is delayed is recommended.