Friday, May 13, 2022 / by Teresa Dipeso
What is a bridge loan? As the name suggests, bridge loans offer a short-term loan or “bridge” that allows borrowers to purchase new real estate property by using the home they currently own as collateral. A bridge loan is definitely worth considering for borrowers who are trying to buy and sell a home at the same time.
What is a bridge loan?
Also called a “wrap” or “gap financing,” bridge loans are a lifeline for home buyers who are eager to purchase new digs before they’ve sold the home they’re currently in. In such scenarios, unless you’ve got substantial income and wads of cash for the down payment, it can be hard to qualify for the loan amount of that new home while you are still saddled with monthly payments on the mortgage loan on your current home—for many people, that means stretching their finances awfully thin.
While some lenders may be reluctant to grant borrowers a loan for that new home, lenders also know that the odds are good that the borrower will sell his old house soon enough—and then be flush. A short-term bridge loan helps span that gap.
How bridge loans work
Typically, for a bridge loan, you can finance up to 80% of the combined value of both homes. So if you’re selling a home for $200,000 and buying another one for $300,000, you can borrow $400,000 max. As for the rest (in this case, $100,000), you’ll need that handy either in home equity, savings for a down payment, or some combination of the two. Once your home sells, you pay off the bridge loan and then apply for a new longer-term mortgage with a more favorable interest rate to refinance just your new home.
Bridge loans typically take a shorter time to process than conventional loans (a couple of weeks versus a few months) and are meant to be short-term solutions (often three months to a year). However, since lenders can’t make much money in interest in such a short time, they typically charge borrowers a higher interest rate and fees than lenders would on a standard home loan.
In the current market, lenders charge bridge loan interest rates in the range from 6% to 16%. You may be able to find lenders that offer an interest-only, fixed-rate loan for the length of time you need bridge financing.
With interest rates like that, the idea is to pay the bridge loan off as quickly as possible, as soon as you sell your previous real estate. (That said, some lenders have a prepayment penalty while others don’t, so do make sure to read the fine print.)
Lenders may charge borrowers substantial origination fees on bridge loans—consider it the price you pay for the convenience of getting a short-term loan.
Pros and cons of bridge loans
What is a bridge loan best for? With one of these loans, you can make an offer on a new home without a financing contingency, which means that you’ll buy the home only if you can secure a new mortgage. Odds are, the person selling the home you hope to buy doesn’t like financing contingencies, since that would mean that your offer is not a sure thing. A bridge loan solves this home-buying problem by guaranteeing the cash needed to close the deal.
Still, bridge loans are rare—requiring an excellent credit score and a low debt-to-income ratio—and you should take time to consider “what is a bridge loan going to do to my long-term finances?”
Even if you’re fairly certain you’ll sell your current home quickly and can pay off this high-interest loan, the real estate market is never a sure thing, and there’s always a possibility that your old home will take far longer to sell than you imagine—or, God forbid, your old home will never sell at all. Then you’re stuck paying high interest rates and big mortgage payments—and if you can’t pay up at the end of the loan term, you could end up losing your home to foreclosure. Granted, most bridge loan lenders are willing to extend the deadline on a bridge loan, but not forever.
Is a bridge loan right for you?
As a general rule, it’s a good gamble if your home is situated in a hot seller’s market, where you are reasonably assured that it will sell in a short time.
If you’re in a seller’s market, it’s generally fine to buy a new house, then sell your old one.
However, if you’re in a buyer’s market, where your home might sit on the market for months or years, it’s much wiser to sell your house and rent something for a short time until you find another home you love. Yes, that means you’ll have to move twice—once into your rental, then once again after you buy a home—but that hassle will pale in comparison to the stress you’ll face when the clock is ticking and you’re making mortgage payments on a bridge loan. So make sure you’re a good candidate before you go out on this limb.