Bridge loan: What is it and how is it best used by homebuyers and investors?
What is a bridge loan?
A bridge loan, also known as a swing loan is a short-term loan that enables homeowners and homebuyers to bridge the gap between the purchase of their new property and the sale of their current property. Typically used by real estate investors, developers, and homeowners who need to purchase a new property before they have sold their current property, these types of loans work best for borrowers who have a strong credit history and a sizable amount of equity in their current home.
In order to go about getting a bridge loan, you must first find a lender that offers bridge financing. This can usually be found at traditional banks, private lenders, or online lenders.
Once you have identified a lender, you need to provide them with all of the information about your current home and also the new property you wish to purchase. Usually you will also include any closing costs or estimates for the new house that you are wanting to buy. The documents required for this may include your financial or bank statements and property appraisals that determine the current home’s value.
Homebuyers use bridge loans when they want to move forward with purchasing a new home but need to wait for their current home to sell
One of the main reasons someone would want a bridge loan is to quickly move forward with the purchase of a new property without having to wait for their current home to sell.
This typically happens when a homebuyer’s equity is tied up in their current home and they need to move fast to purchase a new home without being able to pull their equity out of the current property in order to buy it. Normally, they cannot pull the equity out of their current home as the home has yet to sell and they do not have the funds to otherwise purchase. Once the home has sold, the buyer would then use the proceeds from the sale to pay off their bridge loan amount.
Bridge loans are popular with real estate investors and property developers who want to take advantage of a timely real estate purchase opportunity and are less affected by the high interest rates that come along with bridge financing.
Bridge loans have higher interest rates and more equity requirements than traditional mortgage loans
There are both pros and cons to these types of loans. One of the main drawbacks of bridge loans is that they come with higher interest rates than traditional mortgages as they are a higher risk for lenders. Additionally, bridge loans are typically short-term options, which means that borrowers need to repay the loan within a short period of time, usually within six months to 24 months of borrowing for their new house. This tight turnaround time for repayment can be challenging for buyers who are waiting for their old home to sell in a slower housing market.
The penalties for not paying a bridge loan in the time allotted can also be very expensive and will vary based on the lender and loan terms.
Common penalties for not paying off a bridge loan in time include:
- Late fees: The lender may charge a fee for every payment made after the due date
- Prepayment penalties: Lenders may charge a fee if you pay off the loan early, before the end of the term, so be sure to check your terms
- Foreclosure: The lender can foreclose on the property used as collateral if you cannot make payments on your loan
- Interest rate penalty: Lender can increase the interest rate on the bridge loan if monthly payments are not made
It's also important to note that if you are unable to pay off a bridge loan, it will have a negative impact on your credit score which will make it hard for you to get approved for future loans of any kind. Make sure to communicate with your lender if you are in a situation that will make paying off your loan difficult, they can work with you on extensions for the loan term and help you find a solution for repayment.
Bridge loans are helpful for people who need to quickly buy a home but have most of their equity tied up in their current home, but they come with a hefty price tag
One of the cons of bridge loans is that they also require the borrower to have a significant amount of equity in their current home. Meaning that their current mortgage or conventional loans are not too high and they have either paid off a lot of their first mortgage loan or made a sizable down payment when purchasing their house.
The equity requirements of bridge loans make them less accessible and desirable for those who do not have a lot of equity in their current home or have a large mortgage loan amount that will impact their earnings when the home sells. It’s important to remind homebuyers that this type of loan is not a long-term financing option, so there are more sizable monthly payments than you would see in typical mortgage payments.
How to get a bridge loan for your home purchase
Below is an outline of the basic steps to take to get a bridge loan for the purchase of a home:
- Identify a lender: Research lenders that offer bridge financing, these typically include traditional banks or private lenders
- Gather your financial documents: Prepare your bank statements, property appraisals, home equity line of credit or HELOC information, home equity loan statements, etc that the lender will need to evaluate your creditworthiness and your property value
- Submit the application: Work with the lender you identified to submit your application for the bridge loan work to begin
- Get approved: Your lender will review your application and assess your creditworthiness to determine if you are approved for the loan and able to complete the loan repayment terms that they require for underwriting. To assess creditworthiness lenders usually look at your credit card debt, cash flow, debt-to-income ratio, any new mortgage loans or personal loans, and your lump sum of cash on hand.
- Loan is funded: If your application is approved, the lender will give you access to the funds and you will be expected to make regular payments on the loan that are spelled out in your loan terms. These payments include interest (usually higher rates) and principal on the loan.
Note that usually you will need to be able to show the lender that you have an exit strategy for your bridge loan that will ensure you can repay it upon your current home’s closing date. Normally the exit strategy is selling your current home, refinancing your current traditional loans (or second mortgage), or selling other assets to pay off the loan within the short-term financing terms.
Remember that upfront qualifications and requirements for bridge loans vary depending on the lender, financing institution, and the specific loan product and terms. Always be sure to consult a financial advisor before taking out a loan for a new purchase, especially if it is dependent on ensuring that your current home sells.
Refinancing a bridge loan is possible, but requires applying for another conventional loan
When a borrower refinances a bridge loan, they are typically replacing the bridge loan with a more permanent conventional loan, such as a traditional mortgage. The refinance process involves applying for a new loan and using the proceeds to pay off the outstanding balance on the bridge loan. Note that many lenders will not refinance a bridge loan if the homebuyer has not yet sold their current house and may require that their home sale be completed before allowing for the refinance.
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