If you're trying to buy a home in a pinch, but your current property hasn't sold, it might be difficult to convince a lender to write another mortgage before you've paid off your existing home. For people who need to close on a property quickly, a bridge loan might be a viable short-term solution.
What Is a Bridge Loan?
Bridge loans provide immediate cash for homeowners in the market for a new home; it lets you put in an offer on a house, even if there's a delay in selling your current property. It's useful for those who want to close on a new home quickly and don't have enough money for the down payment. There are generally two types of bridge loans:
One popular bridge loan is where the lender pays off your existing mortgage and provides enough cash for the down payment on the new property. This process installs a temporary loan that will remain in place until you pay it off with the proceeds of your (hopefully inevitable) home sale.
The other type of bridge loan functions similarly to a personal loan, and covers the down payment on your new house while leaving your existing mortgage untouched. Once you sell your old home, you can use the proceeds of the sale to pay off both the bridge loan and your existing mortgage.
How Does a Bridge Loan Compare to a Regular Mortgage?
The interest rate on your bridge loan will vary according to your terms and financial profile. The lender will generally take into account the loan's duration, your loan to value ratio and your credit score. In the current market, the interest rate will likely range from between 8 – 12%, but will generally sit at a couple of percentage points above the prime rate.
Keep in mind that you'll still be responsible for paying closing costs related to the bridge loan. These include escrow, notary, recording, title, and wire fees. There will also be upfront charges related to the financing, including points, origination and document processing fees. Be sure to review these fees closely when looking over the terms of your new loan agreement.
Due to their temporary nature, bridge loans carry significantly higher interest rates than traditional mortgage loans. However, one of their main benefits is that the processing time will be much faster than conventional loans. You will likely be able to obtain the proceeds of your bridge loan within 2 – 3 weeks of submitting your application.
Is Getting a Bridge Loan a Good Idea?
Bridge loans are meant for people transitioning between homes. Since home purchases usually require exorbitant amounts of money, homeowners who don't have enough money for the down payment on their new home usually need to sell their current property to make ends meet. This can get complicated in a slow market or if your closing is delayed.
In some cases, homeowners may insert a clause into their new home agreement that makes their purchase contingent on the sale of their existing home. This type of agreement may not be agreeable with many home sellers, and is often impractical in a competitive seller's market.
As a short-term solution, a bridge loan eliminate the need for this contingency by using the buyer's existing home as security for the loan. This effectively "bridges" the gap between your current home sale and your future home purchase.
What to Watch Out for When it Comes to Bridge Loans
Bridge loans are meant to act as temporary financing and will cost more than a conventional loan. Homebuyers who can obtain other forms of financing, or who are able to pay bridge loans off quickly may find it in their best interest to do so. The fees and interest rates on bridge loans may not be worth it for those who can obtain cheaper forms of financing.
Additionally, bridge loans count as secured debts, which means that they you may face foreclosure if you're unable to sell your home within an agreed upon term. Oftentimes, a bridge loan lender may be unwilling to grant a loan extension for homes that don't sell. If you default on these loans, the lender can and will foreclose on your house.
Depending on how long it may take to sell your existing property, a bridge loan may not make financial sense. If the closing on your existing home sale is simply delayed by a couple of weeks, you may be better off booking an extended hotel stay. However, if you're sitting on top of the home purchase of your dreams, and you're facing down two or three other prospective buyers, a bridge loan may be worth exploring.
What Other Options do I Have?
If the costs of a bridge loan are too high to justify, you can also consider alternative methods of financing like 401(k) loans. 401(k) loans allow you to borrow against the funds in your retirement account, which you can then repay with interest over time. These entail their own risks and can relate in tax penalties if you're unable to repay them. Additionally, 401(k) loans have the opportunity cost of any potential interest earnings you could have earned. Borrowers should be aware that their 401(k) loan amount may be declared immediately payable if you lose your job while it's outstanding.
An alternative option to 401(k) loans and bridge financing are gift funds from family or close friends. Often, homebuyers will need just enough to cover the down payment on a new property, and a sizable funding gift from a family member can get you over that hill. Obviously, this isn't an option for everybody, but is advisible if you can obtain it. Keep in mind that mortgage lenders may have their own questions regarding whether the funds constitute an actual "gift."
Bridge loans are expensive forms of temporary financing meant for homebuyers in between homes. If you're simply in the market for an investment property or second home, and have no intention of selling your current property, you may be better off exploring other forms of investment home financing.