How does a bridge loan work? Closing the gap between a home sale and home purchase can help you be a more competitive buyer.
Attempting to sell your present home and purchase a new residence can be an exciting but uncertain endeavor.
Homebuyers can find themselves in a stressful situation if they’re depending on the sale of their current house to have enough money to purchase the new one. That’s where a bridge loan may come in handy.
A bridge loan allows you to borrow money for the new property while waiting to sell the old one, using your current home as collateral.
What's in this Article?
A bridge loan is a form of short-term financing that helps you “bridge” the financial gap between selling your current home and buying a new home.
You can use the proceeds from the bridge loan to cover the down payment and closing costs on a new property, which enables you to buy a new home before the first one is sold.
How does a bridge loan work?
The bridge loan is secured by your current property, serving as a kind of “second mortgage.” If you’re wondering why buyers don’t simply get a second mortgage, rather than a bridge loan, here’s why: Lenders don’t want to give mortgages that will be paid off in a few months or years. They don’t make any money on interest. Instead, they offer bridge loans, which may come with higher fees and interest rates. That way, borrowers can pay the loan off quickly once their current property is sold, and the lender still makes a profit.
The repayment timeline on a bridge loan is much shorter than with a standard mortgage loan. Typically, you’ll need to repay the loan within 6-36 months, depending on your lender’s terms.
“The idea is that, once you sell your old house, you’ll pay off the bridge loan,” explains Martin Orefice, CEO of Rent To Own Labs.
To qualify, you’ll need to meet your lender’s borrower requirements for credit score, debt-to-income ratio (DTI)*, and other qualifying factors. You’ll also need sufficient home equity, though lenders may only allow you to borrow up to 80% of your current property’s equity.
Bridge loan pros and cons
There are pros and cons to using a bridge loan. Whether it's worth it or not depends on the particulars of each real estate transaction.
“When trying to buy a house in a highly competitive real estate market, getting approved for a bridge loan can make your offer look more attractive,” says financial expert Jennifer Mays, owner of We Buy Houses in Denver.
That’s because you won’t need a home sale contingency clause in your offer. Contingency clauses stipulate that the buyer’s current home must sell in order for them to purchase the new property. Contingency clauses can spook sellers who are afraid that the original house won’t sell or won’t sell in time for the new deal to close.
Generally speaking, sellers want offers with as few complications as possible.
A bridge loan provides the cash to buy a property without worrying about quickly selling your old one.
A bridge loan can also help you avoid paying for private mortgage insurance (PMI) on your next mortgage loan.
If you cannot afford to put down at least 20% and you plan to take out a conventional loan, you will need to pay PMI, which can equate to between 0.5% to 2.5% of the loan amount annually.
With a bridge loan, you may be able to put down 20% or more, eliminating the need for PMI.
Mays offers the following example to illustrate the potential savings. Assume that you want to buy a $500,000 house, and this is what that looks like without a bridge loan.
|Mortgage preapproval||$475,000 (95% of purchase price)|
|Down payment||$25,000 (5%)|
You have enough money to buy the house, but with a 5% down payment, you’ll have to pay PMI.
“Assume your PMI cost is 1.2%,” Mays says. “You’ll have to pay $5,700 every year until you have reached 20% equity.”
But in this example, you can avoid PMI if you take out a bridge loan for $75,000.
“Let’s say the lender charges a 5.5% rate†. That means your bridge loan of $75,000 would cost you no more than $4,125 per year in interest, which is a lot less than the $5,700 you would pay toward PMI,” Mays says.
Consider, too, that homes are selling quickly in the current hyper-competitive housing market, allowing bridge loans to be paid off fast, which means you will pay less in total interest on that short-term loan than you might expect.
As with any financing option, caveats apply that you'll want to consider to see if a bridge loan will work for you.
Bridge loans carry higher interest rates than other types of loans – typically one or two points higher than for a fixed-rate mortgage loan.
Fortunately, you won’t be paying on the bridge loan nearly as long as you would a mortgage. But the charges can add up, especially if you get a particularly high interest rate.
Secondly, you must be eligible to qualify, usually by having a DTI of less than 43%, a good credit score, and sufficient equity (generally at least 20%) built up in your current home.
“With a bridge loan, you take on more debt that requires your current home to be sold in order to settle the debt. If the real estate market slows down and switches to a buyer’s market, where homes take longer to sell, you could be at risk of defaulting on your bridge loan, which can result in penalties,” cautions Shaun Martin, a real estate expert in Denver.
Keep in mind that your current home may be at risk of foreclosure if you cannot pay off your bridge loan on time. (Recall that your existing home serves as collateral for the bridge loan.) This can happen, for instance, if you cannot sell your home for as much as you desired or it takes much longer to sell.
A bridge loan may work out, but is not your only financing choice when you’re in a pinch. Instead, you could opt for a home equity line of credit (HELOC) or home equity loan, which may charge lower interest rates than a bridge loan.
Or, you could opt for a piggyback (80-10-10) loan, in which you put 10% down on the home, get a primary mortgage loan for 80% of the purchase price, and get a piggyback second mortgage for the remaining 10%.
“If you are seeking a bridge loan primarily to cover your closing costs, it can make a lot more sense to simply roll those expenses into your next mortgage, as the mortgage loan will almost certainly offer lower interest rates than a bridge loan,” Orefice adds.
Additionally, if you are worried about losing out on a great new home, there are companies that will buy your home and enable you to pay cash for the next property. Some will also buy the home you want in cash, and then sell it to you once you’ve qualified for a mortgage.
How does a bridge loan work FAQs
Bridge loans are short-term financing options. That means they typically have to be paid back within as little as six months, although some have longer terms (such as up to 36 months).
A bridge loan bridges the gap between the time you buy a new home and sell your current home—a period when you may need extra money for the next home’s down payment, closing costs, monthly mortgage, or other housing-related expenses. A bridge loan can provide those additional funds until your existing home sells.
Being approved for a bridge loan can make your purchase offer more attractive to a seller, as you can eliminate any home sale contingency. And bridge loan funds can help you sidestep private mortgage insurance fees that you may be on the hook for if you put down less than 20% on a home purchase.
Because your current home is used as collateral for a bridge loan, there is the risk that you could face foreclosure if you cannot pay the bridge loan back on time. This can happen if you cannot sell your current home in a timely fashion or you receive less money in the sale than you had hoped. Also, lenders charge a higher interest rate for bridge loans than fixed-rate mortgage loans and other types of financing
A bridge loan can work as a valuable tool if you find a home you want to purchase but have not yet sold your current home.
“It provides you with an added level of flexibility in your ability to purchase and move,” notes Orefice. “For example, I have been able to help clients move from one city to another, due to a job relocation, with the help of bridge loans. Assume a person has been promoted to a new position in a new city. She wants to buy a house in the new location, but she needs a short-term loan for the down payment because she hasn’t yet sold her current house. A bridge loan can fit the bill perfectly.”
Bridge loans can be particularly useful in the current market, when the competition for homes is fierce and buyers may not have the luxury of waiting to purchase or of including home sale contingencies in their contracts.
- A bridge loan can give you the cash needed to purchase a new home before you sell your current one
- Bridge loans are similar to second mortgages in that they are secured against your house, but they have a much shorter repayment term
- If your house doesn’t sell as quickly as you hoped, you may have a difficult time repaying the bridge loan plus the mortgages on your new and former homes
*Debt-to-income (DTI) ratio is monthly debt/expenses divided by gross monthly income. †Mortgage rate projections are not a reflection of Fairway’s opinion or guarantee of interest rates in the current or upcoming market.