What is a Bridge Loan and How Does it work?
A bridge loan is short-term financing designed to be a “money bridge” between buying and selling a property. These loans offer an ideal financial solution for homeowners ready to purchase a new house while holding a mortgage on their present residence. A bridge loan can help an existing homeowner access equity funds to finance a new house prior to selling their current property.
Bridge loans work by using a portion of a homeowner’s current mortgage as collateral to make a down payment on the new one. For instance, a home valued at $250,000 with $150,000 left on the mortgage means the homeowner has $100,000 in equity to use as collateral against the loan. The typical term for a bridge loan averages between six to twenty-four months. Bridge loan borrowers are required to pay back the full amount at the end of the term, which brings a bit of risk. However, it is also possible for a lender to merge an existing bridge loan with the new mortgage, depending on the financial viability of the borrower.
In today’s tight real estate market, investors must move quickly to close a deal. Bridge financing provides an edge against the competition by solving the cash flow problem and the dilemma of holding dual mortgages.
Investing in Real Estate
Real estate investors planning to renovate and flip a single-family property or invest in a multifamily complex may seek bridge loan financing. It is quite common for a seasoned fix-and-flip investor to offer an “all-cash deal” to be competitive in a tight housing market. If the property needs considerable renovations, there might not be enough cash left over to cover the cost of the rehab. This is when bridge lending would come into play. In this case, they would use the property itself as the collateral, making it a hard money bridge loan. Most lenders will offer to loan up to 90% of the property’s value since borrowers secure the loan with the asset.
Another example would be individuals wanting to invest in a multifamily real estate. It is considerably more expensive to buy an apartment complex than a single-family rental, as multifamily properties can run into the millions. And, if the investment property needs extensive repairs, investors might look for a short-term loan to cover the renovation costs. Traditional banks tend to shy away from lending enormous amounts of capital to renovate a distressed multifamily asset. Taking out a bridge loan to make the repairs will help get the property stabilized, making it easier to secure long-term financing.
Bridge Loans for Business
A business ready for expansion may choose to use a bridge financing as an option to secure a commercial property when financial resources are limited. Bridge loans provide immediate working capital to complete an acquisition until the borrower can secure long-term financing.
Both large and small business owners might use a bridge loan as an answer to a negative cash flow situation to secure the success of the company. For example, if a business uses an invoicing system and there is a delay in customer payment, securing a loan to “bridge the gap” would be a workable option for covering payroll, utilities, rent, and other expenses until customers remit. The amount owed on the invoices could work as a source of collateral for the business loan. Lenders might refer to this as accounts receivable financing.
The Pros and Cons of Bridge Loans
While bridge financing is available to real estate investors or business owners seeking a rapid capital remedy, residential homeowners are the ones most likely to seek a temporary loan solution for a transitional phase in homeownership. This can happen to a person who finds their dream home and does not want to risk losing it or if someone needs to relocate for a job. Short-term financing can help homeowners resolve either of these predicaments. However, bridge loan borrowers should consider the costs, benefits, and drawbacks of these kind of money loans before taking the next step.
Pros of Bridge Loans:
- Short-term loans with quicker turnaround on approval.
Most traditional banks will not lend against an existing property. Leveraging home equity through a bridge loan means immediate access to financing for a down payment. Residential property owners can make an offer on a new home without using a contract contingency. Lenders place less emphasis on a borrower’s credit score when a property is used as collateral.
- Homeowners can take more time to sell their existing residence.
The borrower can close the deal, move into the new house, and then wait for a fair offer on their current property. Today’s tight real estate market means most homes sell within the traditional timeframe of the loan.
- Access to more cash.
It is possible for homeowners to consider using their home equity line of credit to borrow money for a down payment on a new home. If their available credit line is too low, a private lender can advance a larger amount of cash through their bridge loan programs.
- Avoid the expense and inconvenience of moving twice.
Transitioning from one home to another can be challenging when the homeowner is ready to move; yet remains saddled with the current residence. In this scenario, most homebuyers go with the option of placing their furniture in storage and moving to a temporary rental. The storage fees, rent payments, security deposits, and the cost of moving twice can be expensive and burdensome. Bridge loan financing means the borrower can take immediate possession of the new home and avoid the hassle.
Cons of Bridge Loans:
- Traditionally more expensive with higher interest rates, increased transactions and closing costs.
The fast approval speed and brief lifespan of hard money bridge loans create a higher expense for the borrower. Loan originators put in a considerable amount of work in a short period of time to process the loans. This means lenders can justify the higher interest rates and closing costs, while also charge more for the transaction.
- High-risk option.
The short timeframe of the loan could be problematic. If the borrower’s former residence does not sell as expected, the homeowner risks losing the property used as collateral.
- Additional expense.
Getting a bridge loan means owning multiple properties. Homeowners could end up having to pay two mortgages if it takes too long for the old home to sell. Interest and late payment fees on the bridge loan will add up until the property sells and the loan gets repaid.
How to Find the Best Lender?
Conventional banks would rather not finance short-term loans. Borrowers looking to fill a money gap with a bridge loan should seek a private money or hard money lender. It is easier for a borrower to get private financing through these lenders because of their fast approval process and looser credit scrutiny. Private lenders are experienced bridge loan pros who understand how to leverage equity in exchange for capital.
Bridging a loan comes at a higher expense; so, it is important to scrutinize multiple lenders before choosing one. The easiest way to find the best lender is to compare loan costs. Keeping in mind that offering the lowest loan interest rate does not mean it is the cheapest option. Borrowers must also take into consideration transaction costs, loan origination fees, and prepayment penalties. Research multiple private lenders online and explore their website, looking for existing deals and client testimonials. Make a list of the various private lenders and their terms to compare rates, fees, loan requirements, and penalties.
Naturally, the ideal place to begin when seeking a lender would be to get referrals from friends and family. The best kind of reference comes from a borrower who has experience using a particular lender.
Bridge loans serve as a valuable option for borrowers who need fast access to funds. Acquiring this type of short-term financing can bridge the gap between financial transactions or resolve a temporary business predicament. While bridge financing is a bit more expensive, the costs may well turn out to be more beneficial overall. With that said, borrowers should perform extensive due diligence to ensure they understand the pros and cons of bridge loans to choose the best lender.