A bridge loan is a short-term loan that provides financing between buying a home and selling your previous one.
It’s not unusual for real estate students to come across different types of loans in their real estate exams. One such loan is the bridge loan, which the student must learn to define properly. If you’re stuck with the concept, I’ll help you out!
In this detailed guide about bridge loans, I’ll define bridge loans with the help of an example. After reading this post, you’ll be able to understand this loan and differentiate it from other loans.
What Is a Bridge Loan?
A bridge loan provides short-term financing to homeowners while moving from one house to another.
This type of loan is beneficial if the homeowner needs extra cash for a new home purchase before moving out from their existing home. It provides immediate cash flow to purchase a piece of real estate. Since this loan bridges the gap between purchasing a new home and selling the previous one, it is also known as a gap loan or interim loan.
The interest rates on a bridge loan are high as they provide short-term financing. The rates are between 8.5% and 10.5%; thus, they are more expensive than conventional loans. A bridge loan is secured by collateral, including the borrower’s home or other assets.
Bridge loans are helpful for homeowners who need immediate financing, such as those who want to relocate urgently. Sometimes these loans are also used to retrieve a home from foreclosure or to close on a property immediately.
How Does a Bridge Loan Work?
Individuals and businesses use bridge loans to cover the gap when they need funds, but they aren’t yet available. The period for these loans is mostly 6 to 12 months, and the rates can be equal to the prime rate or 2 percentage points above the prime rate.
When a person purchases a new home, they have two options. First, the borrower must include a contingency contract for the house they wish to buy. According to this contingency, the borrower can buy the new house only after selling the previous house. However, some sellers don’t need this option if the homebuyer is ready to purchase a home immediately.
The second option is to make a down payment for the new home before selling the house where the homebuyer currently lives. This is where bridge loans are used. In this case, a homebuyer can use a bridge loan to use the funds for a down payment for the new house. For a bridge loan, the old house acts as collateral. In most cases, a bridge loan is 80% of the combined value of both homes.
Not all financial institutions offer these loans; thus, the borrower must shop around and find a lender for bridge loans. Lenders offer these loans to borrowers with excellent credit scores and a low debt-to-income ratio. These loans are risky for the borrowers as they offer higher interest than other short-term financing options such as a Home Equity Line of Credit or HELOC.
Bridge Loan Costs
Bridge loans help the borrower repay the existing mortgage and initiate the next purchase. Since these loans involve more risk, they have at least 2% higher rates than traditional loans. However, the exact rate depends on the lender and the borrower’s credit history. But the fact remains the same: bridge loans are more expensive than traditional mortgages.
Besides higher interest rates, the borrower has to pay other costs, including closing costs and additional fees. These costs can be anywhere between 1.5% and 3% of the total loan amount. Apart from the monthly mortgage payments, the bridge loan costs include the following:
- Appraisal fee
- Administration fee
- Escrow fee
- Loan origination fee
- Notary fee
- Title policy fee
Types of Bridge Loans
Bridge loans vary according to the costs, terms, and conditions. The following are the different types of bridge loans:
Closed Bridge Loan
A closed bridge loan is for a fixed period, as agreed by the borrower and the lender. Lenders offer these loans this way; they are more sure of the loan repayment date. These loans have lower interest rates than open bridge loans. The lower interest rates are because the closed bridge loans offer more certainty of repayment to the lender.
Open Bridge Loan
An open bridge loan has no fixed repayment date as with a closed bridge loan. These loans are preferred by homeowners who don’t know when they’ll have access to funds. Due to the loan repayment date uncertainty, lenders charge a higher interest rate for these loans.
First Charge Bridge Loan
A first charge bridge loan is when the property used as collateral has no other encumbrance. In this loan, the collateral is in complete ownership of the borrower because they have fully paid the mortgage. Thus, the loan provider has the primary right to the property and can sell the property if the borrower defaults. Since the lender has certainty regarding the property, this loan’s interest rates are low.
Second Charge Bridge Loan
A second charge bridge loan is when the lender holds a secondary right to the property. The lender in this type of loan has a second charge after the first charge lender. These loans have higher interest rates because they are riskier than the first charge bridge loans. If the borrower defaults on the loan, the lender will have a right to the property after the primary lender.
Pros of Bridge Loans
- Funds from bridge loans are useful for immediate transactions
- The borrower gets quick access to cash
- Flexibility to shop for real estate
- No contingency is required, meaning the borrower doesn’t have to sell their home.
- Easy qualification and quick approval than conventional loans
- The borrower can make interest-only monthly payments
- The borrower can make a larger down payment for the purchase of a new home
Cons of Bridge Loans
- The borrower can lose both homes if they don’t repay the bridge loan.
- High-interest rates and closing costs
- The bridge loan provider is difficult to find
- The loan is riskier than other loans
- Short repayment time
Bridge Loan Example
Sally lives in a home that is worth $200,000. She has paid a mortgage of $150,000 on this property, and the existing mortgage balance is $50,000. She decides to move into a new house near her workplace, but before that, she must clear her mortgage balance on the property she currently lives in.
After discussing with a loan officer, Sally takes a bridge loan of $80,000. Of this $80,000 amount, $50,000 goes toward paying the current home’s mortgage balance. She has $30,000 to make a down payment for the new home.
Frequently Asked Questions
What are the Requirements for a Bridge Loan?
To qualify for a bridge loan, the borrowers must meet the following criteria:
• Legal ownership of the home
• Resident individual
• Low loan-to-value ratio
• Low debt-to-income ratio
• Excellent credit score and history
• At least 20% equity in the current home
What are the Different Types of Bridge Loans?
The different types of bridge loans include closed bridge loans, open bridge loans, first-charge bridge loans, and second-charge bridge loans.
How to Repay a Bridge Loan?
Bridge loans last from 6 months to 12 months. The borrower is required to make interest payments every month. Most borrowers repay their bridge loans by using the money from selling their current homes. The repayment structure of bridge loans varies, but mostly a balloon payment is required where the borrower pays the full amount at the due date.
What are the Alternatives to Bridge Loans?
A bridge loan isn’t the only way to arrange quick funds. Borrowers can use other loans, such as personal loans, cash-out refinances home equity loans, and home equity lines of credit (HELOC). These loans also provide long-term financing options as compared to bridge loans.
A home equity loan allows the borrower to borrow against their home equity in a lump sum. On the other hand, a HELOC allows the borrower to get cash when needed.
Who Should Take a Bridge Loan?
Borrowers should take bridge loans if they purchase a new house before selling their existing home. They can use a portion of the bridge loan to pay off the current mortgage and the rest to make a down payment for purchasing the new home. A bridge loan is a good fit if:
1. The borrower can’t afford a down payment for the purchase of a new home
2. The homebuyer wants to purchase a house that sells quickly, and they can’t wait for the previous house to sell
What to Know for the Real Estate Exam
Bridge loans fill financial gaps by offering funds to the borrower for moving from one home to another. These loans allow the borrowers to move forward if they are stuck between two ends. For instance, a bridge loan is a good option if the borrower’s current home isn’t selling and they need cash to purchase a new home. These loans are short-term loans and have higher interest rates than other loans.
I hope that you’ve understood how bridge loans work in real estate. But that’s not it; there are many such real estate terms that you should learn. Go through these Real Estate Flashcards before you take your real estate exam.