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No matter how well we plan and how disciplined we are in saving – sometimes we need extra cash to cover a specific event or expense. This is especially a common scenario when it comes to buying and selling houses. Your money is tied up in your current home, but you desperately need to make the down payment on your new dream home. This is where bridge loans come in.
Bridge loan – what is it and how can one help you? Below we explain a bit more about the two questions, what is a bridge loan and how does a bridge loan work?
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If you are asking, “What is a bridge loan?”, the answer is quite simple. A bridge loan is a loan you take out when you are stuck between needing finance and getting finance. Bridge loans are, therefore, a form of interim financing that comes in when you need financing but the permanent financing you want is not yet available. The purpose is to help with cash flow. A good example where bridging loans are often used is when you are in between selling your current home and buying your new one. You want to finance your new home with the proceeds from your old home, but you haven’t sold it yet and you need to make down payments on your new house. Bridge loans come in at this gap.
Bridge loans are usually backed by some form of collateral and tend to have high interest rates.
Different lenders have different requirements when it comes to providing bridge loans. There are, therefore, not really any general guidelines when it comes to a minimum credit score or required income. Many lenders approach bridge loans on a “does it make sense” basis.
The answer to, “How does a bridge loan work?” can best be explained with an example. Let’s continue with our example of buying and selling a house. You want to buy a new home and you have a lot of equity in your existing home. In order to buy the new home you need to make a down payment but you might not have the necessary cash flow. This is where the bridge loan will come in. You will take out the bridge loan in order to be able to make the down payment and you will use the proceeds of your existing home to repay the bridge loan.
With this scenario, you will be borrowing your down payment on your new home and you are securing your bridge loan with your existing house.
Bridge loans shouldn’t just be used for anything, as the cost of a bridge loan is quite high. The ideal situation where a bridge loan will come in handy and can be used is our example of buying and selling a house.
If you first had to sell your existing loan in order to get the necessary cash or equity to make the down payment on your new one, you would have to move out of your existing house and find a temporary house. Only once your funds or equity become available after the sale of your current house (which might take a while if the money is in escrow) will you be able to purchase a new home. This means you have to move again! What a costly and unnecessary exercise.
If you take out a bridge loan, you only have to sell your existing house once you have purchased your new house. The proceeds from the sale can be used to pay back the bridge loan and you only have to move once.
A personal loan can also be used to serve the purpose of a bridge loan. Some lenders might be willing to provide a personal loan to help you cover the gaps. If you are a foreign national who will be taking out a mortgage but need bridge financing before you get your foreign mortgage, consider Stilt. Stilt provides loans to immigrants and might be able to solve your financing needs.
The rates and fees you’ll pay for a bridge loan will vary from lender to lender. Some bridge loans have the option to not make any payments for a certain period of time while interest accrues. The interest is payable when the loan is paid back in the end.
An example of some of the fees you can expect when taking out a bridging loan is as follows (these are just average examples – the actual amount will differ based on lender and location):
Many bridge loans also have origination fees which are based on the amount of the loan. This is a cost that can catch you off guard so make sure you look out for these in the terms and conditions.
As with all loans, there are pros and cons you will need to weigh up before you take out a bridge loan. We provide some guidance on these below.
Here are some benefits of taking out a bridge loan:
The main drawback of a bridge loan is the higher cost. Bridge loans cost more than home equity loans as interest rates are higher and they have a higher transaction cost. You can expect the fees listed above to pop up when you take out a bridge loan which you won’t find with a home equity loan.
If you are stuck between a rock and a hard place when buying and selling homes, a bridge loan could be the answer. If you have equity in your existing home, or you can use the proceeds of its sale to pay back the bridge loan, a bridge loan is a good option for you. If you won’t be able to pay off the bridge loan with such proceeds, you might want to reconsider.
If the cash flow isn’t needed urgently and a home equity loan is an option, you might want to consider this first as well. A home equity loan will cost you less than a bridge loan.
As bridge loans don’t generally have a minimum credit score or income requirements, a bridge loan will probably be an option if you aren’t able to get a loan elsewhere. You should, however, think twice when this is the only reason you will opt for a bridge loan. The additional cost and risk might not be worth it.
We hope you can now answer the questions, “What is a bridge loan?” and “How does a bridge loan work?” Bridge loans can be great solutions if you are between homes and need some help to cover the financing gap. As long as you are prepared for the cost that comes with it and you use it for the right purposes, bridge loans can help you get out between a rock and a very hard place.
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