A loan that facilitates funding gaps, just like bridges facilitate physical gaps.
What is a Bridge Loan?
A bridge loan is a short-term form of financing that is used to meet current obligations before securing permanent financing. It provides immediate cash flow when funding is needed but is not yet available. A bridge loan comes with relatively high interest rates and must be backed by some form of collateral such as business inventory or real estate property. The loan can be accessed by either individuals and companies to meet certain obligations.
Bridge loans are usually arranged within a short time and with little documentation. For example, if there is a lag between the purchase of a real estate property and the disposal of another property, the buyer may take a bridge loan to facilitate the purchase. In this case, the original property becomes the collateral for the loan. Once long-term financing is available, it is used to pay back the bridge loan and also meet other capitalization needs. Bridge loans are mainly used in real estate to retrieve property from foreclosure or to close on a property quickly.
How Do They Work?
A bridge loan is used in the real estate industry to make a down payment for a new home. As a homeowner looking to buy a new house, you have two options.
The first option is to include a contingency in the contract for the house you intend to buy. The contingency would state that you will only buy the house after the sale of your old house is complete. However, some sellers might reject this option if other ready buyers are willing to purchase the house instantly.
The second option is to get a loan to pay a down payment for the house before the sale of the first house goes through. You can take a bridge loan and use your old house as collateral for the loan. The proceeds can then be used to pay a down payment for the new house and cover the costs of the loan. In most cases, the lender will offer a bridge loan worth approximately 80% of the combined value of both houses.
Business owners and companies can also take bridge loans to finance working capital and cover expenses as they await long-term financing. They can use the bridge loan to cover expenses such as utility bills, payroll, rent, and inventory costs. Distressed businesses can also take up bridge loans to ensure the smooth running of the business, while they search for a large investor or acquirer. The lender can then take an equity position in the company to protect its interests in the company.
Pros and Cons of Bridge Loans
For home-buyers, bridge loans can be a risky proposition. Not only are you adding to your existing mortgage debt burden, but there is no guarantee your old home will sell before the term of the loan is up. This could leave you in a sticky financial situation as you would have to pay off the loan without having the proceeds from the sale of your house. For business owners or investors, bridge loans can oftentimes make sense when purchasing commercial real estate or getting cash-flow help while waiting for long-term financing.
- Quickly purchase a property that you would lose if you waited for traditional financing
- Ability to purchase a “move-up” home or property
- No payment may be required on the loan until term is up
- Get time to prepare a commercial property for a traditional commercial mortgage
- Cash-flow infusion for businesses and startups until they can close long-term financing
- High interest rates and fees
- Increased debt burden could lead to undue financial stress or default
- Can be difficult to qualify for these loans (you may have to be qualified to have two mortgages)
- No guarantee old house or property will sell before term of the loan is up
- Some loans may have prepayment penalties
We recommend home-buyers try to sell their old home before purchasing a new home to avoid taking out a bridge loan. However, if this is not possible, we suggest borrowers consider other options. You should see whether you can qualify for a home buyer’s assistance or down payment program. If that’s not an option, home equity loans and lines of credit can be used in the same way as a bridge loan and will likely have lower interest rates.