What is a Bridge Loan, and How Does it Work?

If you buy a new home before you sell your current home, you might consider a bridge loan. A bridge loan could help you cover the cost of a new property in the short term. However, it does come with some risks that you should carefully consider.¹ Below, we’ll dive deeper into what a bridge loan is, how it works, the cost and benefits, and alternative solutions you may want to think about.

What is a bridge loan?

Also referred to as a gap loan, a bridge loan is often used in real estate transactions to temporarily help homeowners bridge the gap between the purchase of a new home and selling their current home.

Bridge loans are different from mortgage loans, because they are considered short-term loans.

With a bridge loan, you may receive funds to purchase your new home before you put your current one on the market.²

How does a bridge loan work?

Bridge loans vary both in structure and terms, but they do share some traits. Bridge loans are secured loans that are typically offered in 6- to 12-month terms. With a secured loan, you need collateral, or something of value that you use to back the loan. If you are unable to make payments, the lender may claim the collateral to offset their costs. In the case of a bridge loan, your home is the collateral. If you fail to pay, the bridge loan lender can foreclose on your home, even if you’re also paying a mortgage.

If you qualify for a bridge loan, you may be able to borrow anywhere from $10,000 up to more than $1 million.³ Payment options may vary, with some lenders offering monthly or interest-only payments, while other ask for upfront payments or one-time payments at the end of the loan term (known as balloon payments). Some lenders may make you start paying back a bridge loan right away, while others have repayment terms that let you wait until you sell your house. Interest rates can vary based on the lender, your personal credit history and current market conditions, although interest rates on bridge loans are usually higher than traditional mortgage loans.⁴

When you apply for a bridge loan, most lenders will look for the following criteria:

• Credit score: You typically need strong credit to secure a bridge loan. Some lenders look for credit scores in the 700s.⁵
• Debt-to-income (DTI) ratio: Your DTI ratio shows how your debt payments compare to your monthly gross income. Some lenders allow your DTI ratio to go up to 50%, although if you are financing multiple properties, it may be difficult to stay under that threshold.⁶
• Home equity: Bridge loan lenders usually look for you to have at least 20% equity in your current home.⁷ To find out how much equity you have in your home, subtract your total mortgage balance from the estimated market value of your property.

Pros and cons of bridge loans

Here’s a quick look at the advantages and disadvantages of bridge loans.⁸

Pros

• Quick access to funds: You may not have to wait long for a bridge loan. Depending on the lender, you may be able to access the loan in as fast as two weeks.⁹
• Flexible payments: With some lenders, you may defer your bridge loan payments until you sell your current home. If you’re on a tight budget, this payment flexibility could be a huge plus.
• Eliminates the need for a contingency: With a bridge loan, you may put an offer on a property without a sale contingency, which is a clause that says the purchase of a home will only go through if you sell your current home first. With no contingency, you could increase your chances of getting your offer accepted.

Cons

• Higher cost: Bridge loans are usually more expensive than traditional mortgages due to higher interest rates.
• Amount of equity needed: Most lenders want to ensure you have enough equity in your home. In most cases, you’ll need to show at least 20% equity for a bridge loan approval.
• Right to foreclose: If you’re unable to pay back your bridge loan because you can't sell your home, the bridge loan lender may foreclose on your property, even if you have been making mortgage payments.

Alternatives to bridge loans

Bridge loans aren’t the only short-term financing option that might help with a home purchase. It’s a good idea to explore alternative solutions, including:¹⁰

• Personal loan: With a personal loan, you receive a lump sum of money at one time. You repay the loan over a set period, ranging from a few months to a few years or even longer, in smaller, easier to manage payments. Since a personal loan might be unsecured, meaning you don’t have to put up collateral to secure the loan, you don’t necessarily need to worry about losing your home if you can’t make your payments. However, you likely won’t be able to finance the entire purchase of a new home with a personal loan. Personal loans typically have maximum amounts that are less than the average price of a home, and some mortgage lenders won’t allow you to use them for down payments.
• Home equity loan: A home equity loan is a lump sum amount that you borrow against your home’s equity. Like a bridge loan, it’s secured by your home, which is considered the collateral. However, a home equity loan typically comes with a lower, fixed interest rate and longer repayment term.
• Home equity line of credit (HELOC): Like a home equity loan, a HELOC taps into your home equity and treats your home as collateral. A HELOC is different from a home equity loan in that it’s a revolving line of credit, much like a credit card, and lets you borrow money from the line of credit as needed, as long as you don’t go over your credit limit and continue to regularly repay what you’ve already borrowed. However, lenders may not consider your home for a HELOC if it’s up for sale.

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Bridge the gap with confidence

A bridge loan can help you buy a new house while you work to sell your current one. However, it’s important to take a close look at your finances, understand the risks involved and consider alternative solutions before signing on the dotted line. By doing your research, you could determine whether a bridge loan is a good fit for your situation or if you’d be better off with another option, like a personal loan or home equity loan.

Sources

1,2,3,4,7,6,8,9,10 https://www.bankrate.com/mortgages/bridge-loan/

5 https://www.experian.com/blogs/ask-experian/what-is-a-bridge-loan/