Bridge Loans: Why They’re Needed and How They Work

A “bridge loan” is essentially a short term loan taken out by a borrower against their current property to finance the purchase of a new property.

Also known as a swing loan, gap financing, or interim financing, a bridge loan is typically good for a six month period, but can extend up to 12 months.

Most bridge loans carry an interest rate roughly double the average fixed-rate product and come with equally high closing costs.

Bridge loans are generally taken out when a borrower is looking to upgrade to a bigger home, and haven’t yet sold their current home.

A bridge loan essentially “bridges the gap” between the time the old property is sold and the new property is purchased.

Bridge Loans Can Help You Drop Home Buying Contingencies

• If the home you want is in a competitive housing market
• Home sellers typically won’t agree to contingencies from the buyer
• To solve the buy before you sell quandary
• A bridge loan might be a good solution to fill the gap

Many purchase contracts have contingencies that allow the buyer to agree to the terms only if certain actions occur.

For example, a buyer may not have to go through with the purchase of the new home they are in contract for unless they’re able to sell their old home first.

This gives the home buyer protection in the event no one buys their old home, or if nobody is willing to buy the property at the terms they desire.

But when a home seller won’t accept the buyer’s contingency, a bridge loan might be the next best way to finance the new home.

In fact, some real estate companies have partnered with lenders to extend bridge loans at no cost, including large brokerage Compass.

How Do Bridge Loans Work?

• A bridge loan can be used to pay off the loan(s) on your existing property
• So you can buy a new property without selling your current one
• Or it can act as a second/third mortgage behind your existing loan to finance a new home purchase
• It may not require monthly payments, just payment in full once you sell

A bridge loan can be structured so it completely pays off the existing liens on the current property, or as a second loan on top of the existing lien(s).

In the first case, the bridge loan pays off all existing liens, and uses the excess as down payment for the new home.

In the latter example, the bridge loan is opened as a second or third mortgage, and is used solely as the down payment for the new property.

If you choose the first option, you likely won’t make monthly payments on your bridge loan, but instead you’ll make mortgage payments on your new home.

And once your old house sells, you’ll use the proceeds to pay off the bridge loan, including the associated interest and remaining balance.

If you choose the second option, you’ll still need to make payments on your old mortgage(s) and the new mortgage attached to your new property, which can stretch even the most well-off homeowner’s budget.

However, you likely won’t need to make monthly payments on the bridge loan, which can make qualifying for the new mortgage easier.

Either way, make sure you’re able to take on such payments for up to a year if necessary.

Most consumers don’t use bridge loans because they generally aren’t needed during housing booms and hot markets.

For example, if your home goes on the market and sells within a month, it’s typically not necessary to take out a bridge loan.

But if the housing market cools off, they might be more common as sellers experience more difficulty in unloading their homes.

They may also come into play if the new property is highly sought-after and you need a stronger offer (e.g. larger down payment) for acceptance.

Bridge Loan Rates Are Typically Quite High

• One downside to bridge loans are the high interest rates
• Relative to longer-term, traditional financing options
• But because the loans are only intended to be kept for a short period of time
• The interest rate may not matter all much that

As noted, interest rates on bridge loans can be costly, typically double or higher than what you’d receive on a traditional home loan.

Like a standard mortgage, the interest rate can vary widely depending on all the attributes of the loan and the borrower.

Simply put, the more risk you present to the bridge lender, the higher your rate will be.

For example, if you need a very high-LTV loan and you’ve got marginal credit, expect an even higher rate.

But if you’ve got excellent credit and plenty of home equity, and just need a small loan to bridge the gap, the interest rate may not be all that bad.

And remember, these loans come with short terms, so the high cost of interest will only affect your pocketbook for a few months to a year or so.

Just be mindful of the closing costs associated, which are often also inflated because lenders know you’ll be fairly desperate to obtain financing.

Bridge Loans Can Be Risky

• Be careful when you take out a bridge loan
• As there’s no guarantee your existing home will sell in a timely manner
• Pay attention to all the terms of the loan and watch out for hefty fees prepayment penalties!
• Consider alternatives like HELOCs or home equity loans

Many critics find bridge loans to be risky, as the borrower essentially takes on a new loan with a higher interest rate and no guarantee the old property will sell within the allotted life of the bridge loan. Or at all.

However, borrowers usually doesn’t need to pay interest in remaining months if their home is sold before the term of the bridge loan is complete.

But watch out for prepayment penalties that hit you if you pay the loan off too early!

Make sure you do plenty of research before selling your home to see what asking prices are and how long homes are generally listed before they’re ultimately sold.

The market may be strong enough that you don’t need a bridge loan.

But if you do need one, be aware that a home could go unsold for six months or longer, so negotiate terms that allow for an extension to the bridge loan if necessary.

If you think a bridge loan is right for you, try to work out a deal with a single lender that provides both your bridge loan and long-term mortgage.

Usually they’ll give you a better deal, and a safety net as opposed to going with two different banks or lenders.

Also keep in mind that there are other alternatives to a bridge loan such as financing down payments with your 401k, stocks, and other assets.

It may also be possible to use funds from a HELOC for down payment, which may prove to be the cheaper option.

The downside to a HELOC or home equity loan is that you might have trouble qualifying if your DTI ratio includes your existing mortgage payment, future mortgage payment, and the home equity line/loan payment.

There are also iBuyers that will buy your old home almost instantly, allowing you to purchase a replacement property with ease, but they may not pay top dollar. And again, fees are a concern.

When all is said and done, a contingency may provide the best value, even if it takes some convincing and additional legwork.

Whatever you decide, take the time to consider the pros and cons of each scenario before moving forward.