Bridge Loans Guide 2021CASAPLORERTrusted & Transparent
What is a bridge loan?
A bridge loan is a short-term loan that provides liquidity and financing during the transitionary period when the borrower’s existing home has not sold, and the new home is in closing. It essentially allows individuals to ‘bridge’ the gap between the two transactions of selling an existing home and using those funds to buy a new home.
In most cases, it is very difficult to time the selling of your current home and purchase of a new home, therefore, bridge loans help ensure that you can buy your new home without needing to have funds immediately available from the sale of your current home. Bridge loans are short-term that are paid back within 12 months. They have relatively higher interest rates as compared to mortgages and are secured by collateral on your existing home.
How do bridge loans work?
Bridge loans can be structured in various ways. The two main methods used by lenders are:
1. Second Mortgage: Pays down payment on the new home
In this method, you borrow funds based on the equity you own in your existing home, which is then used to pay for the down payment on the new home. You can borrow up to 85% of the home value after you subtract the outstanding balance. This is a second mortgage that works in a similar fashion to a Home Equity Loan, where the existing home is used as collateral. In this method, there will be a period where you will be maintaining your existing home mortgage and would have closed on the new home.
For example, if your existing home is valued at $400,000 and has an outstanding balance of $250,000, this means that you have $150,000 in home equity. If you borrow up to 85% of the home value, which is $340,000 ($400,000*85%), you will get a total bridge loan of $90,000 ($340,000 - $250,000). If closing costs and fees for the bridge loan are around $15,000, you will have $75,000 available. This $75,000 can be used by you to cover the down payment for the new home, while your current home is in the process of being sold.
In order to determine how much you will be eligible for in this method, use our HELOC calculator which calculates your equity and eligible borrowing amount.
2. Lump-sum Loan: Existing mortgage payoff and down payment on the new home
In this method, you borrow funds based on the value of your existing home. These funds are then used to pay off the remaining mortgage balance with any additional funds to be used for the down payment on the new home. You can borrow up to 80% of the home value in this case.
For example, if your home is valued at $400,000 and has an outstanding balance of $250,000, you can borrow a lump sum of $320,000 ($400,000*80%). Out of the $320,000 that you can borrow, the outstanding balance to be paid is $250,000, leaving an additional $70,000 ($320,000 - $250,000) to be used for the down payment of your new home.
In both methods, it is assumed that the loan is being taken with your current home as collateral and that the home will sell fairly soon. Once the home is sold, the funds from the sale are used to pay off the bridge loan and accrued interest. In the event the home does not sell, the entire bridge loan will be due along with the new monthly mortgage payments. This can result in severe financial strain and may eventually result in you defaulting on one or both of the debt payments. Therefore, although bridge loans provide an elegant solution to the issue of lack of liquidity, it can also result in default and foreclosure.
Advantages and Disadvantages of Bridge Loans
There are several advantages and disadvantages to using a bridge loan.
- No need for sale-contingent offers: When you are purchasing a home, there is a clause that allows you as a buyer to back out of a purchase deal if your current home does not sell. In a seller’s market where there are several buyers for a single home, a sale contingent offer can be looked down upon as the buyer has the option to leave the deal if their existing home does not sell. Sellers do not like this as they are not guaranteed that the deal will go through. Therefore, bridge loans allow the buyer to place an offer without the sale contingency offer, making their offer much more attractive.
- Fast access to cash: You get immediate access to cash liquidity which can then be used for the minimum down payment on your new home.
- Interest-only or deferred payments: The payments required for the bridge loan may be interest-only or deferred until you sell your existing home. This can give you flexibility as the payments can be made once the term of the bridge loan is over, which should be after the existing home is sold.
- Quick process time: In general, bridge loans require less time to be processed as the underwriting and funding process is faster than traditional loans.
- High-interest rate: As these are short-term loans that can involve risks for the lender, they charge a higher interest rate on the loan. Some lenders also give a variable rate that is tied to a benchmark index, like the Prime rate, which is connected to the Fed funds rate.
- Appraisal requirement: Apart from fees and other costs, you might also require an appraisal which adds to the cost of getting a bridge loan.
- Need at least 20% home equity: You are required to have at least 20% equity in your existing home or an LTV ratio of 80% if you are to be eligible for a bridge loan.
- Home as collateral: Since the home is the collateral, any default in payments can result in foreclosure.
- Debt repayments: After a certain period of time, you could be paying a mortgage on your existing home and making repayments on the bridge loan. This can result in financial stress or default.
When should I use a bridge loan?
There are certain cases where the use of a bridge loan can be extremely helpful.
- Location: If you are in a seller’s market and they do not accept sale contingent offers, you will be required to get a bridge loan.
- Down payment: If you cannot make the minimum down payment on your new home while making debt payments on your existing home, then a bridge loan could help make up the difference.
- Timing: You have found the new home you want to buy but have not been able to receive the funds from the sale of your existing home. Rather than losing the buying opportunity, you can use a bridge loan to provide liquidity during the transitionary period.
- Preference: You would rather close on your new home before selling your existing home.
What other alternatives are there apart from bridge loans?
If you feel bridge loans are not the right option for you because of the higher interest or the risk, there are other alternatives available:
- Home equity line of credit (HELOC): A HELOC allows homeowners to borrow funds by using the equity they own in their home as collateral. Most lenders allow up to 80% of the home value to be borrowed. HELOC functions like a credit card where funds can be borrowed and paid back, giving a lot of flexibility to the borrower. HELOCs charge a lower interest rate than bridge loans, however, they cannot be used if the home is up for sale. Therefore, if a HELOC is being used for the purpose of providing liquidity then it should be used to buy the new home first and then sell the existing home. You can check your monthly HELOC payment using our HELOC payment calculator.
- Home equity loan: A home equity loan is similar to a HELOC where you borrow funds based on the equity you own in the home, however, instead of it being a line of credit, it is a lump-sum amount. Home equity loans are also cheaper than bridge loans as they have lower interest-rate charges.
- 80-10-10: In this loan, you first take a mortgage on the new home for 80% of the home value, following which you take a second mortgage for 10%, and you pay the remaining 10% out of pocket. Once your existing home sells, you use those funds to pay off the second mortgage. This strategy allows you to put little upfront and avoid private mortgage insurance (PMI), as the overall down payment is more than 20%.
Applying for a Bridge Loan
What are the requirements and eligibility criteria for a bridge loan?
Bridge loans have similar requirements to a mortgage. The basic requirements are as follows.
|LTV Ratio < 80%||A loan-to-value (LTV) ratio of at least 80%. You must have at least 20% equity in the home for a bridge loan.|
|Credit score > 620||The minimum credit score required by your mortgage lender and program, which in most cases should be greater than 620.|
|DTI Ratio < 43%||The minimum debt-to-income (DTI) ratio required by your mortgage lender and program, which in most cases should be less than 43%.|
What are the costs of a bridge loan?
The interest rates offered on bridge loans are higher than conventional loans, however, since these loans are taken for a short period of time, it does not have a large impact. Interest charged on a bridge loan is usually prime rate + 2%. Other fees associated with a bridge loan can account for up to 2% of the loan value, and includes the following:
- Administration charges
- Appraisal costs
- Title policy fee
- Escrow costs
- Wiring and notary fees