How does a bridge loan work?
In real estate, a bridge loan helps homebuyers “bridge the gap” when transitioning from one home to another. Bridge loans, also known as gap financing and “swing loans,” provide short-term financing by tapping into your home’s existing equity. This gives you immediate access to as much as 80% of your home’s value.
If you’re in the process of selling your current home, you don’t have to wait until it sells to buy a new one. You can use a bridge loan to cover any number of expenses relating to your new home, such as inspection fees, closing costs, or even the down payment.
In this way, bridge loans can give you a much-needed edge in a competitive housing market, offering increased buying power regardless of when you sell your existing property.
How and when do you repay a bridge loan?
The exact terms of a bridge loan can vary depending on the lender. In general, however, bridge loans are often repaid within 3-12 months. In some cases, you can wait until the close of your bridge loan before you start making monthly payments, though this option hinges on the preferences of your lender and the terms of the loan itself.
Most often, your bridge loan will have a balloon payment at the end, at which point the loan must be paid in full. Fortunately, you’ll be able to pay the loan using the funds you receive once you sell your current home.
If for some reason your current home is taking longer than usual to sell, your lender may extend your loan period, though usually not by more than a few months.
Bridge loan: Pros and cons
What is a bridge loan best designed to accomplish, and when might it be wise to avoid relying on one? Bridge loans offer several advantages and disadvantages, which you’ll need to consider before taking out a bridge loan.
-
Pros
Some of the advantages of a bridge loan include:
- The freedom to buy a new house before selling your current home
- Additional cash flow during your first couple months of homeownership
- No need for a sales contingency, making you a more competitive buyer
These benefits make bridge loans a valuable tool for homebuyers going through a transition period in a turbulent housing market.
-
Cons
Along with the aforementioned advantages, bridge loans can come with several distinct disadvantages, including:
- Higher interest rates and APR compared to other loan types
- Occasional requirements to obtain a mortgage through the lender before they offer you a loan
- General unavailability if you lack 20% equity in your existing home
Despite these disadvantages, many homebuyers can’t beat the flexibility of a bridge loan, making them an excellent financial vehicle that helps you purchase a home without worrying about getting the timing just right.
When should you use a bridge loan?
The question, “What is a bridge loan?” is often followed-up by the equally important question, “When is such a loan useful?”
There are several scenarios in which a bridge loan can be practical.
-
You need to buy a house before you sell your current one
In a perfect world, you’d sell your home the same day you buy a new one. But in the real world, closing dates don’t match up.
Ordinarily, you’d need to include a sales contingency in your contract, meaning you’d only complete the purchase of the new home when your current home sells. A bridge loan helps you avoid this contingency, making it easier to work with sellers and may help you stand out from other buyers.
-
You need money for a down payment (and want to avoid PMI)
Historically, traditional loans have required a down payment of at least 20%. While many lenders will accept significantly less, you’ll be required to pay private mortgage insurance (PMI) if you make less than a 20% down payment.
A bridge loan can provide funding to make a full 20% down payment, eliminating the added cost (and hassle) of PMI payments.
-
You need extra money for the first couple of months
Bridge loans can provide funding during the first few months of homeownership. You can use this money to help with moving expenses or necessary repairs or improvements the seller failed to address.
Depending on your lender, you may be able to defer monthly payments for the first few months or make interest-only payments until you sell your home.
-
When should you not use a bridge loan?
As helpful as bridge loans can be, there are several circumstances where using them doesn’t make sense.
-
You don’t want to deal with higher interest rates
Bridge loans have a higher interest rate and APR than other types of loans (e.g., the mortgage itself). So while bridge loans are convenient, they bring added costs that some homebuyers might want to avoid.
-
You don’t have 20% equity in your home
Many lenders require you to have at least 20% equity in your home. This means that if you’re selling your house after recently buying it, you may not be able to take advantage of a bridge loan.
-
You don’t want to risk having two mortgages at the same time
Bridge loans make it easier to buy a house before selling an existing property, but this also means that you may end up holding two mortgages at the same time. Not only could that make your situation complicated, financially speaking, but you could also risk foreclosure if you’re unable to meet your financial obligations.
Bridge loan vs. HELOC
A home equity line of credit (HELOC) also lets you tap into your home equity and might be a useful alternative to a bridge loan.
A HELOC works similarly to a consumer credit card. Homeowners can draw out as much as they need up to a certain credit limit, and as long as they pay back this amount, they can continue to draw.
A HELOC can therefore be advantageous for ongoing demands (such as home improvements), where you don’t necessarily know how much money you’ll need. Additionally, a HELOC doesn’t come with the high interest rates that a bridge loan does, and you can potentially deduct these interest payments from your income taxes.
Best of all, a HELOC consists of a draw period followed by a repayment period. In some cases, the repayment period doesn’t begin until ten years from the start of the loan, which can take the pressure off when buying or renovating a home.
With all that said, there are still times when a bridge loan may be superior to a HELOC. Bridge loans are better for securing large lump sums, which can better equip you to make a down payment or cover other essential expenses when buying a new house.
Not only does a HELOC not provide this kind of funding, but some homeowners can shortsightedly use their HELOC without paying attention to how much they’re actually spending. When the repayment period comes, they may be surprised at how much debt they’ve accrued.
On the other hand, a bridge loan is straightforward and can be directly integrated into your budget.
Is a bridge loan right for me?
Buying a house is tricky enough as it is without having to worry about the timing of major financial decisions.
A bridge loan can help you make your next purchase without having to lower the price of the home you’re selling. It can improve your agility in a competitive market and make you more attractive to sellers since you won’t need to issue a sales contingency as part of your contract.
