Like their name implies, bridge loans span financial gaps for individuals and corporations for personal and professional uses. These loans are popular in some markets, including the real estate market, where they can be invaluable to buyers who already own a home and decide to purchase a new one. In business, a bridge loan offers positive cash flow while the business closes on long-term financing.
Although these loans have solid benefits, they also come at a price. Relatively high interest rates can make bridge loans tricky to navigate, which causes many experts to warn against using them. Read on to learn exactly what a bridge loan is, what it does and what it might cost before deciding whether or not this is a smart solution for your needs.
Bridge Loan Definition
Bridge loans, also commonly called “swing loans” or “gap financing,” provide short-term financing to “bridge” the gap while an individual or a company secures more permanent financing. These short-term loans offer immediate cash flow for users who need to meet obligations while they set up their long-term financing.
A homeowner who needs a temporary solution to fill in the gap between selling his or her existing home and buying a new one often turns to bridge loans. Bridge loans are also used for multifamily or commercial properties when the buyer needs funds to complete the sale of the property and/or prepare it to meet the required standards of a long-term loan. You normally need to back a bridge loan with some form of collateral, such as your home or inventory from a business. When you use commercial property as collateral for one of these loans, it’s called a commercial bridge loan.
Bridge Loan Rates
Although the rates vary depending on factors such as your creditworthiness and the current prime rates, these loans typically carry a rate that’s around 2% above the average for fixed-rate loans. They also may include hefty closing costs that help offset the lender’s increased risk level. Risks might include securing the financing with a property in need of rehab to meet lending standards, lending to a borrower who doesn’t meet the standards for traditional financing or providing financing in special circumstances, a situation in which most traditional lenders don’t deal.
Because of the higher risk, you should expect higher rates and increased up-front costs. Before taking a bridge loan, consult an experienced advisor to answer any questions or to have this professional walk you through the process.
Bridge Loan Costs: An Example
To further illustrate the potential costs, have a look at an example. Robert, who lives in Idaho, buys a new home while still in the process of selling his existing home. He gets a bridge loan to continue making his mortgage payments on time. Assume that the interest rate for a bridge loan in Idaho is 8.5%. The terms provide no payments for four months and interest that accrues throughout the loan, which is due upon the sale of Robert’s old house. Here’s an example of typical fees associated with bridge loans that Robert finds included in his loan:
- Administration fees: $850
- Appraisal fee: $475
- Escrow fee: $450
- Title: $450+
- Notary fees: $40
- Wiring fees: $75
- Loan origination fee: 1%+ of the loan amount
As this example demonstrates, although Robert needs the extra funding, the money comes at a high cost. Before taking his loan, Robert researched all of his options and was aware of all the associated fees, and he still decided that this was the right choice. The lender used Robert’s old home as collateral to secure the bridge loan.
Bridge Loan Lenders
Not all banks, mortgage companies and finance companies provide bridge loans. Borrowers often have to search for specialized lenders who offer these short-term loans. Checking with your local bank is a good starting point, although you can also search online to find and compare lenders.
In some cases, bridge loan lenders invite qualified investors to help provide this type of financing in exchange for an annual return to the investor. For example, a lender might extend the investment opportunity to Corporation A with a potential of a 6% annual return and terms of holding the investment for 1–5 years. The lender might also provide an incentive to investors who opt to hold the investment for the longest term. Using the above example, if Corporation A opts for a 5-year term, the lender provides an additional 1% incentive, for a total annual return of 7% over the 5-year period.
How Does a Bridge Loan Work?
Some lenders may require you to meet a minimum credit score or low debt-to-income ratio level, but many bridge loan lenders don’t have hard-and-fast guidelines. Instead, these loans are often contingent on the long-term financing the borrower is in the process of procuring. For example, using Robert’s home-buying experience, because his new mortgage comes from a traditional lender at a standard rate, his bridge loan lender is willing to accept a higher-than-average debt-to-income ratio. If Robert was taking on a jumbo loan for his new mortgage, the bridge loan lender would have restricted him to a 50% debt-to-income ratio.
The structures of most bridge loans vary. Some borrowers structure their loans to pay off all the existing liens on a property, while others use their bridge loans as second loans on top of their existing liens. In the first case, once your existing home sells, the proceeds go toward paying off the bridge loan, first and foremost. In the second case, you continue making payments on your old and new mortgages using the funds from the loan to stretch your budget. The proceeds from selling your old house still go toward paying off the bridge loan, including all the interest that has accrued.
If you have good credit and substantial equity, there may be better options, including a home equity loan, which won’t come with the high interest rate and fees associated with a bridge loan. If you’re in need of extra funds to bridge the gap, you can take advantage of the bridge loan option to move from Point A to Point B — or House A to House B. Research the interest rate, fees and terms associated with a bridge loan before pursuing one. Additionally, you can take advantage of a bridge loan calculator, many of which are readily available online, to estimate your potential costs.