How does a bridge loan work?

Many homeowners who are moving rely on money they’ll get from the sale of their current home to fund the purchase of a new one. But closing dates don’t always align, and when that happens, you can find yourself in a precarious financial balancing act.

A bridge loan can help provide funding for the purchase of a new home if you were relying on the funds from sale of your existing home to purchase the new one. But there are drawbacks to this kind of short-term borrowing aimed at “bridging” a financial gap.

Let’s look at how bridge loans work, who might qualify for one and the pros and cons of this type of short-term financing.

• What is a bridge loan?
• How can you use a bridge loan?
• How do you repay a bridge loan?
• Pros and cons of bridge loans

What is a bridge loan?

A bridge loan is a type of short-term loan that may be used in real estate transactions when the buyer lacks the funds to finance the purchase of the new property without the prior sale of the first property.

“A bridge loan is temporary financing to provide a way — figuratively, a ‘bridge’ — to purchase an additional home without first selling a home,” says Michael Hausam, a real estate and mortgage broker with the Hausam Group at Vista Pacific Realty in Irvine, California.

The maximum amount you can borrow with a bridge loan is usually 80% of the combined value of your current home and the home you want to buy, though each lender may have a different standard. For example, if your current home is worth $250,000 and the home you want to buy is worth $330,000, your maximum bridge loan amount would be calculated this way: ($250,000 + $330,000) x .80 = $464,000.

As you read, you might ask, “What’s equity in a home?”. Equity is the difference between the current market value of your home and what you owe.

How can you use a bridge loan?

A bridge loan in real estate can be used to buy another home before you sell your current one. A bridge loan essentially helps fund your new home purchase. For example, you might use it to cover closing costs for a new mortgage.

You can also use a bridge loan to present an offer without a financing contingency when you make an offer to purchase a home. A financing contingency is a contract clause that allows a buyer to get back money put down without penalty in the case the buyer cannot secure financing. Sellers tend to prefer offers with fewer contingencies, but it’s important to have protections in place in case you can’t secure funding.

A bridge loan can also help you get a leg up over other buyers in a hot housing market. For example, if a seller is interested in a quick sale (and many are), the seller may be more willing to make a good deal for a buyer who has the money to close quickly.

How do you repay a bridge loan?

Bridge loans typically must be repaid within 12 months or less. Most people pay off their bridge loan with money from the sale of their current home, but there are other repayment options. Bridge loans may be structured in a number of different ways but commonly have a balloon payment at the end where the full amount is due by a certain date.

You may be able to wait a few months after the close of the bridge loan before you have to start making payments, though this will depend on the particular loan you have been approved for.

Pros and cons of bridge loans

As with any loan product, bridge loans have potential advantages and potential disadvantages for borrowers. Before applying for any kind of loan, it’s important to understand and weigh the pros and cons.

Pros of bridge loans

• Faster financing: The application process and closing on a bridge loan typically takes less time than other types of loans.
• Purchasing flexibility: Getting approved for a bridge loan can give you the funds you need to close on a new home before you sell your current one. That means if you find a home you love, you might be able to buy it without waiting for your old home to sell.
• Remove contingencies from your offer: Sellers may look more favorably on purchase offers that aren’t contingent upon the sale of another home.
• Less housing hassle: You can use a bridge loan to help buy a new house before selling an existing home.

Cons of bridge loans

“Compared with conventional loans, bridge loans are more expensive with greater upfront fees and higher rates,” Hausam says.

• High interest rates: Since lenders have less time to make money on a bridge loan because of their shorter terms, they tend to charge higher interest rates for this type of short-term financing than for conventional loans.
• Origination fees: Lenders typically charge fees to “originate” a loan. Origination fees for bridge loans can be high — as much as 3% of the loan value.
• Equity required: Because a bridge loan uses your current home as collateral for a loan on a new home, lenders often require a certain amount of equity in your existing home to qualify, for example 20%.
• Sound finances: To be approved for a bridge loan typically requires strong credit and stable finances. Lenders may set minimum credit scores and debt-to-income ratios. Generally speaking, if your financial situation is shaky, it could be difficult to get a bridge loan.

Perhaps the biggest risk of a bridge loan is that if your home doesn’t sell by the time you need to begin repaying your bridge loan, you’re still responsible for the debt. Until your old home sells, you’ll essentially be paying three loans: the two mortgages on the houses and then also the bridge loan.

And because the bridge loan is secured by your first home as collateral, if you default on your bridge loan, the lender may even be able to foreclose on the home that you are trying to sell.

Bottom line

A bridge loan might seem attractive, but you should weigh the costs and risks carefully. Before you apply, you might want to consider other options, such as a home equity line of credit, personal loan, 401(k) loan or home equity conversion mortgage. These types of loans could also help you move out of your current home and into your new one, and potentially without the level of risk interest and fees associated with bridge loans.

*Approval Odds are not a guarantee of approval. Credit Karma determines Approval Odds by comparing your credit profile to other Credit Karma members who were approved for the personal loan, or whether you meet certain criteria determined by the lender. Of course, there’s no such thing as a sure thing, but knowing your Approval Odds may help you narrow down your choices. For example, you may not be approved because you don’t meet the lender’s “ability to pay standard” after they verify your income and employment; or, you already have the maximum number of accounts with that specific lender.