Bridge Loans: What They Are And How They Work In Real Estate
If you’re moving into a new home, a bridge loan is a way to have some extra cash on-hand to ease the transition.
In short, bridge loans solve the financing problem that arises when a home buyer wishes to purchase a new home before their current home sells. While Rocket Mortgage® currently does not offer bridge loans, we know the importance of education regarding home loan topics that matter to you.
Here’s what you need to know about bridge loans.
What Is A Bridge Loan?
Bridge loans are a form of short-term financing that can meet immediate cash flow needs during the time between a demand for cash and its availability. While this short-term loan is commonly used in business while waiting for long-term financing, individuals typically only use them in real estate transactions.
Specifically, a bridge loan is used to eliminate a cash crunch and “bridge the gap” while buying and selling a home simultaneously.
The best situation for a home seller is to have their house under contract and then use money from the sale of that property to buy their net home. But circumstances aren’t always perfect. That’s where bridge loans come in.
In some cases, bridge loans can also help you in a situation where you need a new home quickly. Job transfers are a good example.
How Does A Bridge Loan Work?
There are a few options for bridge loans. These are the two main ways that lenders package these temporary loans to meet the borrower’s needs:
- Hold two loans: In this case, you borrow the difference between your current loan balance and up to 80% of your home’s value. The funds in this second mortgage are applied to the down payment for your second home while you keep your first mortgage intact until you eventually are ready to pay it all off when you sell your home.
- Roll both mortgages into one: This solution allows you to take out one large loan for up to 80% of your home’s value. You pay off the balance of your first mortgage and then apply the second toward the down payment of your next home.
The main reason most home buyers turn to bridge loans is to allow them to put in a contingency-free offer on a new home, meaning that they are saying they can buy the house without selling their existing home.
That can be an important factor in a seller’s market, where a number of buyers might be bidding on a home for sale. A seller is more apt to choose an offer without a contingency because it means they aren’t depending on your house selling to close the transaction.
It can also allow you to make a 20% down payment, which is known as a piggyback loan, which can help you avoid private mortgage insurance (PMI). This insurance is required if you haven’t put at least 20% down as a down payment and it elevates your mortgage payment. That’s why some homeowners prefer to avoid it with a bridge loan.
Also, bridge loans typically run for 6-month or year-long terms.
How Much Can You Borrow On A Bridge Loan?
Your lender’s terms may vary, but in general, with a bridge loan you may borrow up to 80% of your home’s value, but no more.
The Cost Of Bridge Loans: Average Fees And Bridge Loan Rates
Bridge loans can be a handy option to get you out of a jam, but you will pay for that convenience. That’s because the interest rate is higher than with a conventional loan. While interest rates can vary, let’s look at the implications of having a bridge loan with an interest rate that’s 2% higher than on a standard, fixed-rate loan.
On a $250,000 loan that has a 3% interest rate, you might be paying $1,054 for a conventional loan, an amount that would rise to $1,342 with a bridge loan that had a 2% higher interest rate.
The reason for high interest rates on bridge loans is because the lender knows you will only have the loan for a short time. That means that they aren’t able to make money servicing the loan, as in collecting your monthly payment over the long term. They have to charge more interest upfront to make it worth their while to loan you the money at all.
In addition, you’ll need to pay closing costs and fees, as you would with a traditional mortgage. That likely includes administration fees, appraisal fees, escrow, a title policy, notary services and potentially other line items that your lender will explain.
Finally, you’ll pay an origination fee on the loan, based on the amount you’re borrowing. With each point of the origination fee (which your lender will arrive at based on the type of loan you get) you will typically pay about 1% of the total loan amount.
While those fees don’t seem enormous, remember that you can only keep your bridge loan for up to one year – that means that you are likely to be paying those fees again in the near term, when you get the new mortgage that will replace the one that you pay off when your old home sells. These fees are essentially money out of your pocket that you won’t recoup.
For an estimation of what your bridge loan might cost, try this bridge loan calculator that lets you consider different scenarios.
While a bridge loan allows you to buy a new home without delay, it comes at a cost – both in terms of interest closing fees, but also the stress inherent in needing to make two mortgage payments.
Alternatives To Bridge Loans
A bridge loan can appear to be a handy solution when you are in the situation where you want to buy a new home but you still have an obligation on your first one. But they have some inherent costs. If you are in this situation and considering other options, here are some potential alternatives.
Home Equity Line of Credit (HELOC)
A home equity line of credit, also known as a HELOC, allows you to borrow money against the equity you have in your home. It’s a little like a credit card, in that you might be approved for a certain amount, but you are only paying interest on the amount you actually use at any given time.
You may also qualify for a lower interest rate than you would with a bridge loan. However, you might have needed to acquire the HELOC before you put your house on the market, as some lenders won’t grant one to a house that’s currently for sale. You can also use a HELOC to make home improvements.
Home Equity Loans
In this form of financing, you use your current home as collateral, allowing you to borrow against your current home equity. A home equity loan is typically long-term, ranging up to 20 years, and often has better interest rates than bridge loans. You still might need to carry two mortgages with this type of loan, though.
If you’ve kept your credit record solid and have a strong track record of employment and on-time payments, you may be able to get a personal loan. These are secured with personal assets. Terms and conditions will vary by lender.
This is a way to buy a new home without putting 20% down while also avoiding PMI. Here’s a quick overview:
You pay 10% down and secure two mortgages: One for 80% of the new home’s price and a second for the remainder. After you sell your current home, you can use any funds left over after paying the outstanding balance to pay the smaller 10% mortgage on the new property.
Other Bridge Loan FAQs
Bridge loans are a complex financial product, which means you likely have many questions. Of course, so much depends on the borrower’s individual circumstances that it can be hard to answer every question, but here are some general answers to common concerns.
Who is eligible for a bridge loan?
If you are trying to purchase a second home before your first home sells and already have been a good mortgage candidate, you might believe that you are eligible for a bridge loan. However, the borrowing process might feel different from the mortgage loan process.
On the plus side, you are liable to experience a faster application, approval and funding process than you would with a traditional loan, allowing you to get the funds you need to move forward with that second home purchase much faster.
But they are not available to everyone. Fundamentals like low debt-to-income ratios, loan-to-value, credit history and credit score (FICO) score matter. First of all, you’ll need to have a lot of equity in your current home to qualify. Since you’re able to borrow up to 80% of the value of your home, this math only works if your home has appreciated from when you purchased it or you’ve made a significant dent in the principal.
Your lender will also check your debt-to-income ratio, which is the amount of money you have to spend each month, taking into account existing debts like your current mortgage, compared with how much you make. It shows lenders that you are not taking on more debt that you can reasonably handle. Without a low debt-to-income ratio, it can be hard to qualify for a bridge loan, given the cost of two mortgages.
And finally, these loans are typically reserved for those with the best credit histories and credit scores. While the minimum scores likely vary by lender, the higher your credit score, the lower your interest rate will likely be.
What are the benefits of bridge loans?
The main benefit of a bridge loan is that it can allow you to place a contingency-free offer on a new home. In a competitive housing market, less contingencies can make it more likely that the seller considers your offer when they’ve received multiple offers.
It also provides convenience if your family needs to move quickly, such as relocating for a job or a need for a more urgent change in your housing. If you’re in a market where homes languish on the market, you might need to move before you have adequate time for your home to sell.
On the other hand, if your house should sell quickly before you buy another home, you might need to take the expensive, inconvenient step of moving into temporary housing while you find your second home. A bridge loan can help avoid that.
What are the drawbacks of bridge loans?
As mentioned, bridge loans can come with a large expense because you absorb a higher interest rate and the fees associated with an additional mortgage. There’s also the matter of the length of a bridge loan. It’s short term means you’ll have to pay it back quickly. This can be especially stressful if it takes longer to sell your house than expected.
Even if you anticipate repayment of the loan with no problems, unexpected circumstances can complicate your plans. Just having two mortgages to manage can be stressful in and of itself, no matter what your economic circumstances.
In addition, not everyone can qualify. You’ll need sizable equity and a fantastic credit rating to be a good candidate.
Finally, not every lender offers them (including Rocket Mortgage) as they are more of a specialty or niche product. You might have to look for a different lender than the one who has your primary loan. Be sure to ask them first, of course, as they might be able to help you or at least offer a great reference.
The Bottom Line: Are Bridge Loans A Good Idea?
As with any financial vehicle, there is no one-size-fits-all answer to whether a bridge loan is right for you. It depends on your financial situation, your living situation, the economy and more.
A bridge loan can be a convenient way to bridge the gap if you:
- Find the house of your dreams and don’t want to risk a contingent offer
- Need to move right away to take advantage of a new job or other reasons for relocation
It can be a great vehicle to help you meet those needs. However, the high interest rate and closing costs is are expensive. It can be even worse financially if things don’t turn out as you had hoped, and your short-term bridge loan ends before you are ready to pay it off.
Again, weigh all the pros and cons of any mortgage loan before taking the plunge. Make sure you work with a lender who will walk you through all your options and discuss the consequences in depth to help you make the decision that’s best for you and your family.
Are you trying to buy a new house while selling your current home? Talk to one of our home loan experts to see how you might be able to secure some extra cash to make your move less stressful.