What are Bridge Loans and How do they Work?


BY The Lenders Network

what is a bridge loan

5 minute read

Buying a new home when you you own a home with a mortgage can be a tricky situation.

You can’t qualify for a new loan until you your current home is sold.

Unless you want to sell your home and move into a temporary living situation until you move into your new house you’ll need a bridge loan.

We’re going to explain what bridge loans are and how they work, so you can decide for yourself if they would be a good option for you.

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What is a Bridge Loan?

You have three options when trying to buy a new home to replace your current one.

  • Sell your home first then look for a new home
  • Make an offer on a home with a contingency that you must sell your current property to complete the move-up purchase.
  • Get a bridge loan to buy a new home before selling your current one.

A bridge loan is a short-term loan that helps transition a borrower from their current home to the new move-up home. Most people cannot afford two mortgages at the same time due to their debt-to-income ratio.

Bridge loans are secured by the current property to pay off the mortgage and the rest can go towards closing costs, fees, and a down payment on the new home.

They are a short-term loan, usually no more than for 6 months. They usually come with two payment options. To make an interest-only payment each month towards the interest, or pay a lump-sum interest payment when the loan is paid off.

How Does a Bridge Loan Work?

While they sound complicated are they are actually quite simple, here is a bridge loan example; Let’s say your current home is valued at $300,000 and your existing mortgage loan has a $150,000 balance. You have found a new home you wish to purchase for $450,000.

A mortgage lender may give you up to 80% of the loan-to-value ratio of your current home, in this case 80% of the home’s value is $240,000. $150,000 of which will go towards paying off your current mortgage. The remaining $100,000 will go towards closing costs for the bridge loan and a down payment on the new loan.

You’re able to move into your new home before selling your current one. Once your property sells you pay off the bridge loan plus any fees and interest and are left with one monthly payment on your new home.

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Pros and Cons of Bridge Loans

Bridge loans are somewhat of a controversy. Financial advisors often strongly discourage their clients to take on a bridge loan and that they should be avoided if at all possible. They come with high lender fees, closing costs, interest rates, origination fees, and lot’s of risks. However, there are also some great benefits of bridge loans.

Pros

  • Move into your new home before selling your current one
  • Immediately put your home up for sale and buy a new home without restrictions
  • Save money on storage and temporary living
  • More attractive offer without any contingencies
  • Interest payments may be delayed and paid at the end of the loan
  • No prepayment penalties

Cons

  • High interest payments
  • Pay closing costs and fees on two loans
  • Risk of foreclosure if your home doesn’t sell
  • Hard to qualify for
  • Increased stress of making 2 mortgage payments
  • Less money in savings
  • High monthly big loan payments
  • Short repayment period
  • Rushing to sell your old home may lead to you accepting less than you want

Conditions of Bridge Loans

Many mortgage lenders offer bridge loans as well as mortgage loans. In many cases the lender will require you to get your new mortgage with them as a condition of providing a bridge loan.

However, this is not always the case. There are lenders that strictly offer bridge loans. Remember these are short-term loans of just 6-12 months. If financing for the new home falls through you will repay the bridge loan lender minus fees and interest, potential costing you thousands of dollars.

If you are approved for the new mortgage but are unable to sell your old home in 6 months, the lender can foreclosed on your old home and take possession of it.

Why Lenders Offer Bridge Loans

  • Borrower have an existing mortgage on their current home
  • Buyers often close on the new home before selling their old one
  • High interest rates make them very profitable
  • Short-term loan terms reduces the risk
  • Even if the borrower defaults on the bridge loan, they take ownership of the property with a 30% equity stake

Reasons to Get a Bridge Loan

Bridge loans are not only when you’re trying to buy a new house before selling your current home. Bridge loans are used by investors, to make repairs, even to fund the construction of a new home if you cannot qualify for a construction loan.

  • Buying a home through an auction and getting the financing without having to put up cash
  • Real estate investors looking for a short-term loan to buy and flip a property as an alternative to a hard money loan
  • A bridge loan can be used to make repairs or renovations to your home before putting it up for sale.
  • Buying a move-up home without contingencies before selling your current home
  • Relocating to a new city to help you purchase a new home giving you time to sell your old one.
  • If building a custom home a bridge loan can provide funds for the construction.

Alternatives to Bridge Loans

Home Equity Loans

The most common alternative to a bridge loan borrowers consider is a home equity loan. A home equity loan is a second mortgage on your home that uses your equity as collateral for a new loan.

They are similar to a cash-out refinance,but require a higher credit score. Home equity loans will have lower mortgage rates than a bridge loan.

The home equity loan will help fund the down payment and other costs associated with buying a home. The problem here is you will be left with 3 loans with monthly payments.

If you’re unable to sell your home quickly, it could lead to defaulting on one, or more of the loans and you could soon be facing foreclosure.

In order for a home equity loan or home equity line of credit (HELOC) to work in the first place is if you have a large income. Most types of loans require you to have a maximum debt-to-income ratio of no more than 36%. With FHA loans some mortgage brokers can go as high as 43%.

But you will have your existing mortgage payment and the home equity loan payment that new to be added to the new mortgage payment. Unless you have an extraordinary income, three mortgage payments will send your DTI ratio well above the maximum allowable DTI ratio.

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Selling Your Home with a Contingency

I think everyone would agree that the ideal situation would be that you get your current home under contract before making an offer on a new one.

You may be able to accomplish this by adding a contingency to home buyers that you have a certain period of time, maybe 15-30 days to find and make an offer on a new house.

If a buyer likes your house enough and is in no rush to move into it, they may be willing to wait a few extra weeks for you to find another home. This way you can sell your current home and get a mortgage loan on the new one at the same time.

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