Are you a homeowner looking to purchase a new property before selling your current one? A bridge loan could be a viable solution. It’s a short-term financing option that can help bridge the gap between the two financial transactions. Here’s what you need to know about these mortgage products and how they work.
What is a Bridge Loan?
A bridge loan is a short-term product designed to help you meet your financial needs during a transition period. These loans are commonly used when you’re in the process of selling your current home and buying a new one and need access to funds to cover the gap between the two transactions.
Bridge loans provide you with the necessary funds to cover expenses like down payments or closing costs on your new home while you are still waiting for the sale of your current home to be finalized. This allows you to secure your new home without having to wait for the proceeds from your current home’s sale.
How Does a Bridge Loan Work?
To secure the bridge loan, you will typically pledge a portion of the equity in your current home as collateral. Keep in mind that a bridge loan is a short-term mortgage, so the loan term typically ranges from a few months to a couple of years.
During the repayment period, you’re responsible for making payments on both your bridge loan and your existing mortgage. When you finally sell your current home, you will use the proceeds from the sale to pay off the bridge loan. It’s worth noting that interest rates on bridge loans are generally higher than conventional mortgage rates, and there might be additional fees to consider as well.
Bridge Loans vs. Traditional Home Loans
When considering financing options for a home, it’s essential to understand the differences between bridge loans and traditional home loans. Both types of loans serve unique purposes, and knowing their features can help you make an informed decision.
For starters, the primary difference between the two is the loan term. Bridge loans are short-term financing solutions designed to help you during transitional periods, such as purchasing a new home before selling your current one. On the other hand, traditional home loans, or mortgages, are long-term loans with repayment periods usually spanning 15 to 30 years.
The application process for bridge loans is often quicker compared to traditional mortgages. Since bridge loans are short-term and usually secured by the equity in your current home, lenders may require less documentation and provide faster approvals. By contrast, traditional home loans have more stringent underwriting criteria, and the applications take much longer to process.
Another key variance is the repayment structure. With bridge loans, you might not need to make monthly payments during the loan term, as they typically require a lump-sum payment at the end. This can be beneficial if you’re waiting for the proceeds from the sale of your current home. However, traditional mortgages require consistent monthly payments, which include principal and interest, over the loan term.
You can also expect higher interest rates with bridge loans. They are riskier for lenders due to their short-term nature and the uncertainty of the borrower’s ability to sell their current home. However, traditional home loans usually offer lower interest rates, as they are secured by the property and have lengthier repayment periods.
It’s also important to note that not all borrowers qualify for a bridge loan. Lenders typically prefer borrowers with strong credit profiles and sufficient equity in their current homes. Meanwhile, traditional home loans are generally more accessible to a broader range of borrowers with varying credit scores and employment histories.
Example of a Bridge Loan
To illustrate how a bridge loan works, assume your current home is worth $250,000, and you have a $100,000 mortgage on it. The new home you want to purchase is worth $330,000. You have sufficient equity in your current home, but you need additional funds for the down payment on the new property.
In this case, with both properties worth a total of $580,000 ($250,000 + $330,000), lenders might offer a bridge loan up to 80 percent of the combined value, which amounts to $464,000.
Next, subtract the outstanding mortgage on your current home from the bridge loan amount: $464,000 – $100,000 = $364,000. This is the net amount that can be used toward the down payment on the new house. When you sell your current home, you can use the proceeds to pay off the bridge loan.
Advantages of a Bridge Loan
Below are some key benefits of bridge loans to keep in mind.
Quick Access to Cash
Since these loans are short-term, they are typically approved and funded faster than traditional mortgages. This can be extremely helpful for you, the borrower, when you’re trying to secure financing to buy a new property before selling your current one.
Flexibility on Payments
Unlike traditional mortgage loans, there are often different repayment structures available to you with a bridge loan. In some cases, monthly interest-only payments can be made during the loan term, giving you more time to sell your existing property. This flexibility allows you to have more control over your cash flow as you manage the transition between properties.
Disadvantages of a Bridge Loan
As with all debt products, bridge loans also come with drawbacks worth considering before making a decision.
Higher Interest Rates
These loans can be quite expensive for borrowers due to the elevated risk they pose to lenders. When you take out a bridge loan, you’ll need to be prepared for these steep borrowing costs and factor them into your budget.
Risks of Default
If you’re unable to sell your current home within the loan period or find long-term financing, you may face the possibility of defaulting on the loan. As a borrower, this can lead to additional financial strain, especially considering the already high-interest rates.
Furthermore, since bridge loans often require home equity as collateral, defaulting on the loan may put your house at risk of foreclosure. This can be particularly concerning if the housing market is slow and the sale of your property takes longer than anticipated.
Evaluating the Terms of a Bridge Loan
If you’re ready to move forward with applying for a bridge loan, here are some key factors to evaluate before applying.
Understand the Fees and Interest Rates
As mentioned above, bridge loans have higher interest rates than traditional mortgages due to their short-term nature and quick closing timeframes. As a borrower, you should expect and prepare for a higher interest rate, which may range anywhere from 8 percent to 12 percent, depending on the lender and your financial situation.
It’s also not uncommon for bridge loans to come with additional fees such as origination fees, closing costs and appraisal fees. These can add up quickly, though, so it’s vital to factor them into your decision when determining if a bridge loan is a good fit.
Identify the Repayment Structure
Bridge loans are designed as short-term loans, meaning they are usually repaid within a short period, which can range from six months to three years. Your repayment plan can be contingent on selling your current property or refinancing your bridge loan with a long-term mortgage to cover the outstanding balance.
In some cases, bridge loans may also come with a balloon payment at the end of the loan term.
When Should You Use a Bridge Loan?
A bridge loan could make financial sense in these situations:
- You need to relocate quickly for work or other personal reasons.
- You’ve found your dream home and don’t want to risk losing it to another buyer.
- You’re buying in a competitive market and want to make a strong cash offer.
The Process of Acquiring Bridge Loans
Below is an overview of what to expect when applying for a bridge loan.
Criteria for Eligibility
To qualify for a bridge loan, lenders usually look at your debt-to-income ratio, home equity, credit score, and possibly your household income. A strong financial background with a good payment history on your current mortgage could significantly increase your approval odds.
The Application Process
When applying for a bridge loan, you’ll typically provide the lender with detailed information on your current home’s worth and the value of the property you wish to purchase.
Most lenders also require the following documents:
- Proof of income (i.e., pay stubs, tax returns, W-2s)
- Recent bank statements
- List of outstanding debts
- Information about your current mortgage
*Note: It’s best to inquire about the documentation requirements with each lender, as they may not be the same across the board.
Once you submit your application, the lender will review the information and assess the risks associated with your request. If the lender deems your financial situation favorable, they may approve the loan.
Deciding if a Bridge Loan is Right for You
Ultimately, deciding if a bridge loan is right for you involves assessing your current financial situation, the timing of your real estate transaction and the costs associated with the loan. It’s equally important to weigh the benefits and drawbacks of these mortgage products and the potential impact on your finances.
