What Is a Bridge Loan?
A bridge loan can help you fund your short-term financial obligations, but it can be expensive. Here’s what you should know before you apply.
September 24, 2021
Moving out of your home and into another is stressful in the best of circumstances, but it’s even more difficult when you’re still trying to sell the old residence while buying the new one.
Bridge loans are useful during these types of situations for helping homeowners keep up with their financial demands. Here’s what you should know about how they work, where to get one, when to use one and what the alternatives are.
What is a bridge loan?
A bridge loan is a form of short-term, high-interest financing that helps borrowers keep up with their financial obligations until they can secure a longer-term loan at a more affordable interest rate — or until some other cash windfall.
Bridge loans are most helpful in scenarios like:
Funding the down payment or carrying costs of a new property until you can sell a previous residence
Covering business expenses until revenues pick up or the business can acquire cheaper financing
Bridge loans typically require collateral. Real estate is the most common choice, but inventory will also work for some businesses. The loans usually last between six months and two years.
Bridge loans can vary significantly in structure: One might pay off an existing mortgage and allow the leftover funds to go toward a down payment, while another might coexist with the original mortgage.
Additionally, some require monthly payments immediately, but others accrue interest and pause installments until a balloon payment at the end of the term.
How does a bridge loan work in conjunction with other loans?
Bridge loans are also called interim or gap financing because they’re best for covering brief periods. To fulfill their intended role, bridge loans are generally quick to close. But be prepared, bridge loans often have significant origination fees and closing costs in addition to their high interest rates.
Ideally, a borrower won’t let the bridge loan remain outstanding for its full repayment term. These loans usually don’t have prepayment fees, so it’s a good idea to try and pay off the bridge loan early to reduce interest costs.
Here’s an example of how bridge loans work: Say your current home is worth $300,000, and your remaining mortgage balance is $200,000. You want to buy a new house that’s worth $200,000, but you don’t have the cash for a 20% down payment.
You could take a bridge loan for up to 80% of your original home’s value, which amounts to $240,000. You could then pay off your mortgage balance on the old property and have $40,000 left to use as a down payment on the new house.
Until your old property sells, you’d have to carry the bridge loan on the old home and the mortgage on the new one; but once it does, you could use the proceeds to pay off the bridge loan plus the interest.
How to shop for a bridge loan
If you need a bridge loan to cover short-term expenses, do your due diligence before applying. They’re not as common a form of financing as traditional housing loans, and lenders may have particular qualification requirements.
Because of their high costs, you probably don’t want to settle for the first one you see, but time is of the essence — otherwise, you wouldn’t want one. Here’s what you should know to help make your shopping experience as efficient as possible.
Bridge loan lenders
Not every mortgage lender offers bridge loans. Lenders may see borrowers who need bridge loans as risky customers, since they'll often be carrying multiple loans at once, increasing the likelihood of default.
One good place to start your search is with the lender you intend to use for your subsequent long-term financing. You can also consider local financial institutions and hard money lenders; both can be flexible with their underwriting and loan structures.
Bridge loan qualifications and eligibility
Bridge loans are usually quick to close but that doesn’t mean the underwriting process isn’t rigorous. Like any other lender, bridge lenders won’t give out financing if they don’t think the borrower can keep up with their debt payments.
For borrowers who want a bridge loan to help them transition into a new residence, lenders will set requirements in areas similar to other mortgage lenders, like:
Equity levels in the previous property: at least 20%
Creditworthiness: usually good to excellent scores
Debt-to-income ratios: using both the previous mortgage and bridge loan amounts
Lenders will do similar underwriting for businesses that need bridge funding to cover expenses like payroll, rent and utilities. They’ll still ask for collateral and examine the creditworthiness and financials of the company.
Consider the alternatives to bridge financing first
Because bridge loan rates and fees are higher than other forms of financing, they should generally be a last resort. Even if you need money to close on your dream home or keep your family business afloat, consider your other options first.
Some possible alternatives are:
Traditional home equity financing: Home equity loans and home equity lines of credit (HELOCs) are typically cheaper than bridge loans in interest rates and closing costs. If you have enough equity in your current property, you can borrow against it with these instead of using a bridge loan.
Low-money-down loans: If you’re having trouble covering the down payment of your next property, see if you can qualify for a loan that doesn’t require 20% down. You may have to pay private mortgage insurance (PMI) on some of them, but there are ways around that, like an 80-10-10 loan.
Business lines of credit: Businesses that need to cover their expenses can apply for a revolving line of credit that they can draw on in emergencies. These are usually cheaper than bridge financing and have the added advantage of being reusable.
Keep in mind that all debt is inherently risky, even these alternatives. Because loans and lines of credit may require collateral such as your home equity or business inventory, you risk a lot if you default on them.
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