Even in the best circumstances, buying a new home can be stressful. For most people, their house is the biggest purchase they’ll ever make, and there are a lot of moving parts to coordinate. The process can be even more complex when you’re home buying and trying to sell your current home at the same time.
As a credit union, we get a lot of questions about bridge loans, which can help to ease the transition from one home to the next. Here are seven bridge loan features you should know about.
What is a Bridge Loan?
You may not be familiar with bridge loans, so let’s start with a definition and an example of when a bridge loan might be useful.
A bridge loan is a short-term loan that is designed to bridge a gap between two events. The term of a bridge loan is typically less than a year and often, it’s less than six months. The interest rates for bridge loans are typically higher than they would be for other types of loans because of the risk involved.
Bridge loans are sometimes referred to by other names, and it’s important to know them. These names include the following:
- Gap financing
- Swing loan
- Interim financing
- Caveat loan
You should know that bridge loans can sometimes be quite large. Some people choose to take out a residential bridge loan to pay off the mortgage for their current home and use any remaining money to put toward the down payment on their new home. A commercial bridge loan may be used to secure interim financing for the purchase or rehabilitation of a commercial property.
How Can Bridge Loans Be Used?
There are two common scenarios where bridge loan financing can be useful, and both are in the world of real estate:
- To provide temporary financing until permanent financing is available or approved.
- To give a borrower time to remove an existing financial obligation.
An example of when bridge financing might be useful is if a homeowner had to move for a job and both buy a new home and sell their existing home. If that person were to find a new home to buy before selling their current house, they might find themselves in a situation where they must come up with a down payment, pay closing costs, and then make two mortgage payments until their current home sells.
Another potential use for a bridge loan would be if a homeowner found a home to buy, but the seller would not agree to make the sale contingent on the sale of their existing home. A bridge loan could be used to allow them to buy the new house without a contingency.
As we noted above, it’s also possible to take out a large bridge loan to pay off your current home completely. This might be particularly useful if you have a lot of equity.
It's easy to see why these situations might put some stress on the homeowner financially. A bridge loan could provide them with the money they need to meet those obligations, giving them the time and resources necessary to sell their existing home.
7 Features of Bridge Loans
Bridge loans have some unique features that differentiate them from mortgages and other types of loans. Here are seven that are important to understand before you apply for a bridge loan.
#1: Bridge Loans Are Short Term Loans
The first thing you need to know is that a bridge loans is a short term loan. Unlike mortgages, which typically have a loan term of 30 years – although some may have terms of 15 or 20 years – bridge loans are designed to be repaid quickly.
As we stated above, most bridge loans have terms of less than a year and many have terms of only a few months. The loan will need to be repaid once the bridge has served its purpose – for example, when your current home is sold, and the closing takes place.
#2: Bridge Loans Must Be Backed by Collateral
Just as a mortgage loan is backed by the house that you buy with the money, bridge loans must be backed by collateral to protect the lender’s position. In real estate, the most common source of collateral is the buyer’s existing home.
For example, if you bought a new home and took out a bridge loan to cover the mortgage on your existing home, your bridge loan would be backed by your existing home. When that house is sold and you close on it, the proceeds from the closing would be used to repay the bridge loan.
#3: Bridge Loans Typically Have Higher Interest Rates Than Mortgages
Another distinguishing characteristic of bridge loans is that they typically have higher interest rates than mortgages. You should expect your rate to be about 2% higher than it would be if you were applying for a traditional loan.
The reason for high bridge loan rates is that bridge loan lenders are taking a risk by lending money for a short period, particularly when repayment is dependent upon something that is out of their control. If a borrower’s home doesn’t sell within the loan term, they might not be able to repay the lender.
One way to look at the higher interest rate is that you’re trading the convenience of short-term borrowing for an interest rate that might be higher than you would like. You’ll have peace of mind as you navigate the sale of your home and for many homeowners, the interest rates are seen as a worthwhile expense.
#4: The Application and Underwriting Process for Bridge Loans is Quick
One of the biggest selling points of a bridge loan is that the loan process, from application to closing, is usually quick – much shorter than the time it would take to apply for and get approved for a conventional loan.
The process is speedy by design. Lenders have the benefit of having collateral and often, an existing relationship with borrowers.
#5: Bridge Loans Don’t Have a Prepayment Penalty
What happens if you get a bridge loan and your home sells shortly thereafter? The good news is that bridge loans do not typically have a prepayment penalty, so you can repay it whenever you can do so.
The advantage of not having a prepayment penalty is that you may not need to pay the full interest amount for your bridge loan. The moment your current home sells and the closing takes place, you can wire funds to the bridge loan lender and repay the loan.
#6: Bridge Loan Eligibility Depends on Home Equity
Bridge loans are available only to homeowners who have a significant amount of equity in the home they’re selling. The typical cut-off for lenders is 20%.
Equity matters because the lender needs to be confident that the sale of your home will generate enough net profit for you to repay the bridge loan.
#7: Bridge Loan Monthly Payments Are Interest Only
The final feature of bridge loans that you should know about is that the monthly payments are typically only interest. You are not required to repay any of the loan principal until your current home is sold (or the bridge loan term expires.)
While interest rates for bridge loans are high, they don’t add much to your monthly financial obligations.
Should You Get a Bridge Loan?
Now that you understand the key features of a bridge loan, let’s examine whether a bridge loan is right for you. As you might expect, there are many things to consider.
What Are the Expenses Associated with a Bridge Loan?
Any loan from any lender has expenses associated with. Before you decide to get a bridge loan, it’s important to understand what costs you should expect.
The key costs involved with getting a bridge loan include the following:
- Loan origination fee
- Property appraisal fee
- Administration fee
- Escrow fee
- Title policy expenses
- Notary fee
As a rule, you can expect to pay between 1.5% and 3% of the loan amount in closing costs and fees.
What Are the Risks Associated with Bridge Loans?
The second significant consideration before applying for a bridge loan is the risk associated with doing so.
The biggest and most obvious risk of getting a bridge loan is that you might not sell your old home before the bridge loan term expires. If that happens, you will be on the hook to repay the bridge loan. It’s for this reason that we typically recommend bridge loans in an active housing market when the likelihood is high that your home will sell quickly.
A related risk is the impact that bridge loan payments will have on your monthly budget. While the payments are interest-only, they can still be significant depending on the amount of your loan and the interest rate. You’ll need to be sure that you can afford the monthly payment before you apply for a loan.
Do You Need a Bridge Loan?
If you currently own a home and you’re planning to sell it and buy a new one, then a bridge loan may help you minimize the stress involved. Leaders Credit Union offers affordable bridge loans that can help you make the transition to your new home.
Are you in the market for a bridge loan? Click here to learn more about Leaders bridge loans and begin the application process.