What is a bridge loan?

A bridge loan can be used if you are in the process of moving from one home to another or if your business needs some temporary financing to help cover operating expenses while waiting for long term funding. 

Keep reading to learn everything you need to know about bridge loans.

What is a bridge loan?

A bridge loan is simply a short-term loan that provides financing during a transitionary period. This can include moving to a new house from your old one, businesses that need to help finance operating expenses while waiting for a loan or funding to come through or even homeowners who suddenly must relocate or move.

A bridge loan is secured by your current home, much like a mortgage or home equity loan. It should be noted that a bridge loan is not a mortgage and cannot be used like one. Bridge loans are specifically designed for short terms, typically needing to be repaid in 6 months to three years. 

How do bridge loans work?

Bridge loans can vary dramatically in their cost, terms and conditions as well as the interest rate. The interest rate may end up being monthly payments, upfront, end-of-the-term or even lump-sum interest payments.

These loans are often used by home sellers or business owners who find themselves in a bit of a bind. While some bridge loans require the old homes first mortgage to be paid off at the bridge loan closing, others may put that debt on top of the old debt. 

While bridge loans can vary there are a number of common elements that all of them share, here are a few of the most common:

• Term: Most bridge loans have a term of 6 to 12 months and are secured by the borrower’s current home. 

• Common lender: Most lenders will not offer a bridge loan unless the borrower is financing their new home with them as well. 
• Interest rate: While the interest can be paid in variety of different ways, the rate typically is the prime rate up to the prime rate plus 2 percent.

The application process for a bridge loan is straightforward and much like a conventional mortgage. A lender will look at your credit score, debt-to-income (DTI) ratio as well as other risk factors. Many lenders will cap the amount you can borrow at 80 percent of the equity you have in your current home.

It should be noted that bridge loans can be expensive. They typically come with closing costs of a few thousand dollars plus up to 2 percent of the loans value. 

The pros and cons of bridge loans

There are both pros and cons to bridge loans and you should consider all of them before you sign on the dotted line. Here is a quick overview of the advantages and disadvantages of bridge loans:

Pros

• Cash: A bridge loan can put cash in your pocked in time sensitive situations. You may be relocating due to a job, and need to find a new house quickly, a bridge loan helps finance your new home before you sell your old one. 
• Quick financing: A bridge loan can typically be done quickly, in most cases quicker than a traditional loan or mortgage. 
• Flexibility: A bridge loan usually offers more payment flexibility than a standard loan. You may be able to defer payments or make interest only payments until your current home sells.

• Eliminates contingency when buying: A bridge loan allows you to shop for a new home without making your offer contingent on you selling your old home. This can be particularly helpful in tight markets where a contingency on your offer may make it less desirable to sellers. 

Cons 

• Two homes: In many bridge loans scenarios you may end up owing two homes at the same time which can result in two mortgage payments as well as double your household expenses. 
• Home equity: The majority of lenders will require that you have 20 percent or more equity in your current home before they will offer a bridge loan. This can be difficult for homeowners who just recently moved into a house as well as first time homebuyers. 
• Lender locked in: Your choice of lenders for your new mortgage will be limited to the lender offering the bridge loan in most cases. 
• Higher interest rates: Due to their short terms, bridge loans often come with higher interest rates than a more conventional loan.

It should be mentioned that bridge loans rarely have protections built into them in the event the sale of your current house falls through. If the sale of your current home falls though, you are still on the hook for the bridge loan amount and the bank can technically foreclose on your current home if you cannot sell it or repay the bridge loan.

Bridge loan costs

A bridge loan is typically more expensive than a conventional mortgage or loan. Interest rates for a bridge loan usually start at the prime rate and go up from there based on your individual risk factors. At the time of writing, the prime rate was 3.25 percent. 

In addition to higher interest rates, a bridge loan comes with closing costs that can range from 2 to 5 percent of the loan amount. Bridge loans also come with a variety of fees which can vary by lender. Here are a few of the more common fees to expect:

• Application fee
• Appraisal fee
• Credit report fee
• Escrow fee
• Home inspection
• Origination fee
• Underwriting fee
• Title insurance and search

When should you consider a bridge loan?

Bridge loans are not for everyone and are typically used in specific circumstances. Here are a few situations where a bridge loan makes sense:

• Purchasing a new home but seller doesn’t want a contingency offer.
• You cannot afford the down payment on a new home until your current home sells
• Closing date for your new home is before you close on your old home
• Your business needs short term financing for operations while waiting on longer term loan or funding