What is a bridge loan?
Updated March 8, 2022
A bridge loan is a short-term loan often used in real estate to provide temporary financing for the company or person until they are able to secure a permanent financing option. Bridge loans are used for up to a year, and they tend to carry high interest rates, often 2% higher than a 30-year standard fixed-rate mortgage.
A bridge loan can also be referred to as interim financing, gap financing, bridge financing, a swing loan or a bridging loan. Bridge loans are most often used by homeowners to borrow the down payment needed to purchase a new home as they wait to find a buyer for their existing home. They are especially beneficial for buyers looking to avoid a contingent-to-sell offer during a seller’s market, enabling them to purchase a new home even if they have yet to sell their existing property.
Borrowers carrying a mortgage. often end up having to make both a mortgage and a bridge loan payment until the initial property is sold. These types of loans provide an immediate cash infusion for the borrower and are often required to be backed by real estate or inventory collateral.
Bridge loans are used for up to a year, and they tend to carry high interest rates, often 2% higher than a 30-year standard fixed-rate mortgage. Credit: Frederick Warren/Unsplash
Only borrowers with excellent credit and low debt-to-income ratios are approved for bridge loans. They are often underwritten by lenders based upon the assessment of the individual borrower as there are not clear guidelines requiring specific debt-to-income ratios or FICO scores. Individual lenders have different underwriting standards for bridge loans as they are not typically sold in the secondary market.
Lenders typically package bridge loans in two different ways. The first option allows homeowners to borrow 80% of their existing home’s value minus their current loan balance. The first mortgage remains the same and the funds are put toward the down payment on the new home. The second option allows borrowers to take out one loan that covers up to 80% of their existing home’s value, which can be used to pay off their first mortgage and the remainder is put toward the down payment on the new home.
The process of applying, getting approval and receiving funding for a bridge loan is much faster than a traditional loan, which is often exactly what borrowers are looking for. This convenience often comes at the cost of large origination fees in addition to high interest rates, which are higher than a home equity line of credit. However, many lenders won’t approve a borrower for a home equity line of credit if their home is on the market.
Many homeowners get a few months without needing to make a payment on their bridge loan, but interest does accrue during those first few months. Borrowers are also granted the flexibility to make payments during periods of increased cash flow as the majority of bridge loans do not incur prepayment penalties.
Bridge loans are not without risk. Borrowers must be able to qualify to own two homes and be willing to carry the large expense of the high interest rate and two mortgages. The short term on the loan can also cause stress, especially if the original home doesn’t sell, as the loan needs to be paid back quickly. Also, not all lenders offer bridge loans as they are considered a specialty product.
Borrowers are often willing to accept the terms of a bridge loan as they plan to pay it off with the long-term, low-interest financing they secure as a more permanent solution.