What is a bridge loan and how do they work?
What is a bridge loan?
A bridge loan is a short-term loan designed to provide financing during a transitionary period, such as moving from one house to another. Homeowners faced with sudden transitions, such as having to relocate for work, might prefer a bridge loan to help with the cost of buying a new home.
Bridge loans are secured by your current home as collateral, just like mortgages, home equity loans and HELOCs. Bridge loans aren’t a substitute for a mortgage, however. Bridge loans are short-term, designed to be repaid within six months to three years.
How does a bridge loan work?
A tool typically used by sellers in a bind, bridge loans vary widely in their terms, costs and conditions. Some are structured so they completely pay off the old home’s first mortgage at the bridge loan’s closing, while others pile the new debt on top of the old.
Borrowers also may encounter loans that deal differently with interest. Some carry monthly 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 percent.
Applying for a bridge loan is similar to a conventional mortgage, in that several factors are used to evaluate your creditworthiness, such as your credit score and debt-to-income (DTI) ratio. Most lenders will also 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 origination fees — and that’s before you even close on your new home mortgage.
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 — if all goes well with the sale of your current home.
Even though 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. Foreclosure could also occur 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.
Pros and cons of bridge loans
Before you decide if home bridge financing is right for you, consider the pros and cons of bridge loans.
Pros of bridge loans
- Cash in hand: Funds from the bridge loan can be used for time-sensitive or quick transactions.
- Fast financing: Bridge loan financing typically takes less time to get funds than the traditional loan process.
- Payment flexibility: A bridge loan offers payment flexibility, including deferred payments until your current home sells and interest-only payments.
- No contingency needed: Rather than place a contingency on your new home purchase that your old home must sell for financial reasons, a bridge loan provides the funds to settle on your new home even if the old one hasn’t sold yet
Cons of bridge loans
- Double the home management: You may end up owning two homes at the same time, which comes with twice the home management and mortgage payments.
- Conventional down payment: Most lenders require the homeowner to have at least 20 percent of home equity in their current home before extending an offer for home bridge financing.
- Financing requirements: The lender may only extend a bridge loan if you agree to use the same lender for your new home mortgage.
- Higher rates: Bridge loans usually get higher interest rates and APR compared to traditional loans.
Typical bridge loan costs
If you get a bridge loan mortgage, be prepared to pay higher interest than a conventional mortgage. Interest rates start at the prime rate — currently 3.25 percent — and increase based on creditworthiness.
At the current prime rate for a conventional loan of $250,000 with a 20 percent down payment, your monthly payments would be about $1,150. Add an extra 2 percent interest for a bridge loan, and that same monthly payment would be $1,380.
You also have to consider closing costs, which are 2 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
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. In these situations, a bridge loan may be a good fit:
- 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, which will sell your current home quickly, and you’ve found your new home.
Where can you find a bridge loan?
Many lenders offer bridge loans, but you’ll usually have to secure one through your current mortgage provider. Speak to your lender if you think your situation calls for a bridge loan.
Alternatives to a bridge loan
- Home equity loans: If you know exactly how much you need to borrow to put a down payment on your new home, a home equity loan may be a solution. It provides a lump-sum payment that is borrowed 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 is similar to a home equity loan in that it draws against the equity of your current home, but it acts like a credit card. The interest rate is only charged if you access the money, and may have a better interest rate than 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, 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: If you’re a business owner, a business line of credit works like a HELOC, only accruing interest on money drawn against it. Loan terms vary by lender, but usually give 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 favorable DTI, you could get approved for a personal loan with a better interest rate than a bridge loan mortgage. Terms and conditions, including if collateral in the form of personal assets are required, vary by lender.
Getting a bridge loan may seem like a good idea if you buy a new home before you sell your old one, but it can be a risky proposition for your finances, and generally, you’re better off waiting to sell the old house first.
While they aren’t the best deal, a bridge loan might be necessary if you’re in a tight spot, such as relocating for work without much advance notice, trying to keep others from beating you to the punch on a property or needing help with the expensive upfront costs of buying a new home before your old one sells.
So, if you do decide to take out a bridge loan, be aware that you’re going to accrue a significant amount of new debt, and may wind up having to pay back multiple loans if your home doesn’t sell quickly.