Bridge loans: What are they and how do they work?

If you’re moving between homes — especially on short notice — a bridge loan can help cover costs. This type of loan isn’t without risk, however. Is it right for your situation? Here’s an overview of bridge loans, and how to decide if one makes sense for you.

What is a bridge loan?

A bridge loan — in some cases referred to as a hard money loan — is a short-term loan designed to provide financing during a transitionary period, such as moving from one house to another. Bridge loans are often secured by your current home as collateral, just like mortgages, home equity loans and HELOCs. Sometimes, however, you can put up other assets for collateral.

Homeowners faced with sudden transitions, such as having to relocate for work, might prefer a bridge loan to help with the costs of buying a new home, either the down payment or the expense of managing mortgages for two properties. Real estate investors often rely on bridge loans, as well, when flipping properties.

How does a bridge loan work?

A tool sellers typically use in a bind, bridge loans vary widely in structures, costs and conditions.

For example, a bridge loan mortgage might involve cashing out equity from your current home and putting that toward a down payment on a new property — or, simply taking out a bigger mortgage for the new property. Another type of bridge loan uses both homes as collateral. Some carry monthly or interest-only payments, while others require either upfront or end-of-the-term, lump-sum interest payments.

Most share a handful of general characteristics, though:

• They usually run for six-month or 12-month terms and are secured by the borrower’s old home.
• Lenders rarely extend a bridge loan unless the borrower agrees to finance the new home’s mortgage with the same institution.
• Rates can range anywhere from the prime rate to the prime rate plus 2 percentage points.

If you qualify, you could borrow a relatively large sum with a bridge loan, anywhere from several hundred thousand dollars to more than $1 million.

Although most buyers get a bridge loan to cover finances between purchasing a new house and selling the old one, they rarely come with protections for the loan holder if the sale of the old home falls through. In such a case, the lender could go as far as to foreclose on the old property after the bridge loan extensions expired, or if you were to have trouble selling your current home.

Given these risks, it’s important to consider a bridge loan carefully based on what you can afford and how quickly homes are selling in your market.

Bridge loan example

Say you get a bridge loan for $70,000, with your current home worth $100,000 and a $50,000 balance left on your mortgage. Of that $70,000, $50,000 would go toward the mortgage, and another $2,000 would go to closing costs. Thanks to the bridge loan, you’d now have $18,000 for your next purchase (assuming all goes well with the sale of your current home).

When to consider a bridge loan

Home bridge financing is used most often when a homeowner plans to buy a new home before selling their current one. A bridge loan might be a good fit if:

• You found a new home, but the seller won’t accept a contingency offer to sell your current home.
• You can’t come up with the down payment for a new purchase unless you sell your current home.
• Your closing date for your current home is after your settlement for the new one.
• You’re in a seller’s market, and you’ve found your new home.

Bridge loan requirements

• Credit score: Because bridge loan lenders have much more underwriting flexibility, you might be able to get a bridge loan with a credit score as low as 500. Other lenders require scores in the high-600s.
• Debt-to-income (DTI) ratio: Some bridge loan lenders allow a DTI ratio as high as 50 percent.
• Equity: If you’re taking a traditional bridge loan, many lenders require at least 15 percent equity in your current home. Others require 20 percent.

How to apply for a bridge loan

Applying for a bridge loan is similar to applying for a regular mortgage in that lenders evaluate several factors regarding your creditworthiness, such as your credit score and DTI ratio. Most lenders only allow you to borrow up to 80 percent of your current home’s equity.

Bridge loans can be costly to get, too. Closing costs are usually a few thousand dollars, plus up to 2 percent of the loan’s original value, and they usually come with an origination fee — and that’s before you even close on your new home mortgage.

Bridge loan rates

If you’re interested in a bridge loan, be prepared for potentially paying a higher interest rate than you would for a standard mortgage. Many lenders base their bridge loan rates on the prime rate (currently at 8.5 percent), while others set their rates a couple of percentage points higher than the prime rate. Bridge loans generally have higher rates than conventional loans, mostly because they’re short-term financing solutions that provide funds quickly — and lenders charge more for this convenience.

Pros and cons of bridge loans

How much does a bridge loan cost?

As we’ve mentioned, bridge loans typically have higher interest rates than traditional mortgages, which increases your borrowing cost.

In addition, you’ll also have to consider closing costs, which are 2 percent to 5 percent of the borrowed amount. There are both mortgage-related and property-related fees that can be included in closing costs, which vary in cost by location and lender:

• Application fee
• Appraisal fee
• Credit report fee
• Escrow fee
• Home inspection
• Origination fee
• Underwriting fee
• Title insurance and search

Alternatives to a bridge loan

• Home equity loan: If you know exactly how much you need to borrow to put a down payment on your new home, a home equity loan might be a solution. You’ll receive a lump-sum payment against the equity in your current home. These loans are longer-term, usually allowing repayment up to 20 years, and usually have more favorable interest rates compared to a bridge loan.
• HELOC: A home equity line of credit (HELOC) is similar to a home equity loan in that it draws against the equity of your current home, but it functions like a credit card. The interest rate is only charged if you access the money, and might be lower than that of a bridge loan. However, this might not be an option with your lender if your current home is up for sale.
• 80/10/10 loan: With an 80/10/10 loan (also known as a piggyback loan), you put down 10 percent and finance two mortgages — the first mortgage for 80 percent of the purchase price and the remaining 10 percent is a second loan. You can use this bridge loan financing alternative and then pay off the second mortgage when your current home sells.
• Business line of credit: A business line of credit works like a HELOC and only accrues interest on money drawn against it. Loan terms vary by lender, but usually allow up to 10 years to pay. These loans are more difficult to get and may have a higher interest rate than a bridge loan.
• Personal loan: If you have good credit and a lower DTI ratio, you could get a personal loan with a better interest rate than a bridge loan mortgage. The terms and conditions, such as collateral in the form of personal assets, vary by lender.

Bottom line on bridge loans

A bridge loan can help you cover the costs of purchasing a new house while you prepare to sell your old one. However, there is a cost for this convenience since bridge loans tend to have higher interest rates than conventional loans. Plus, taking out another loan increases your overall debt load and could put too much financial strain on you. If you’re set on buying a new home before you list your current one, be sure to consider all of your options before you decide on a bridge loan mortgage.