What is a Bridge Loan? | The Motley Fool (2024)

What is a bridge loan?

Bridge financing for homeowners helps smooth the transition from one home to another. A homebuyer can use bridge financing two different ways:

1. A short-term loan for the full value of the existing house. The buyer will receive a bridge loan to pay off the existing mortgage, with the excess going toward the down payment on the new home. Once the sale of the current house closes, the homeowner pays off the entire bridge loan.
2. A second mortgage on the existing home secured by the equity in the property. A homeowner can use those proceeds as a down payment on a new home. They then pay off both the existing mortgage and the bridge loan with the proceeds from selling their home.

By using the equity in their existing house, a homebuyer can finance the down payment on a new home without having to close the sale of the existing property. That way, a homeowner won't have to move into a temporary housing situation if their home sells faster than they expected. It can also give a homebuyer an edge over other buyers in a fast-moving market since they won't have to make a contingent offer.

However, homeowners who are interested in bridge loans need to be aware of four major features of this financing:

1. A borrower needs to have at least 20% equity in their existing home.
2. They must qualify to hold both mortgages.
3. Bridge loans are short-term financing and usually have terms of six to 12 months.
4. Bridge loans have higher interest rates and fees compared to a home equity loan.

What are the pros and cons of a bridge loan for homebuyers?

A bridge loan has its share of benefits and drawbacks for potential homebuyers. The benefits include:

• They enable a home buyer to shop confidently for a new house before listing their old home.
• They give a buyer the ability to make an offer on a home whose seller won't accept contingent offers.
• A homebuyer can close the sale of their new home before their existing one, providing for a smoother transition.

Meanwhile, some of the drawbacks are that:

• They require a fast-moving real estate market to be a practical option.
• They tend to be more expensive, both in interest rate and closing costs, compared to a home equity loan.
• A homeowner needs at least 20% equity in their existing home.
• The homebuyer must be able to qualify to own both homes in case the existing one takes longer to sell than expected.
• A bridge loan can cause financial stress from potentially having to carry two mortgages as well as the mounting interest from the bridge loan.

How much are bridge loan rates?

Bridge loan rates vary depending on the location, lender, and credit quality of the borrower. They'll typically have both closing costs and interest expenses. Borrowers usually use the proceeds of the loan to pay the closing costs, which often include:

• Administration fee
• Appraisal fee
• Escrow fee
• Title policy
• Wiring fee
• Notary fee
• Loan origination fee

Total closing costs can range between 1.5% and 3% of the loan's value.

In addition to that, the loan will accrue interest each month, with lenders typically charging between prime and prime plus 2%. Because the prime rate fluctuates with the interest rate set by the Federal Reserve, a bridge loan's interest rate can vary each month.

Here's an example of the range of costs for a $100,000 bridge loan with a 12-month term using the current prime rate of 4.75%:

Where can you get a bridge loan?

Many lenders will offer bridge loans to homebuyers, including banks, credit unions, online mortgage brokers, and hard money lenders. However, the best place to start is with a local bank or credit union. Check with your real estate agent, as they'll likely be able to recommend several local lenders who have experience with bridge loans. Homebuyers, on the other hand, should try to avoid online hard money lenders since they typically charge the highest fees, and not all are reputable.

What are the risks of a bridge loan?

Bridge financing is riskier for both the lender and borrower, which is why these loans typically have such high costs. The biggest risk is that the borrower's existing home doesn't sell as fast as expected. If that were to happen, not only would interest continue to accrue but the buyer also might need to get an extension, which could incur additional fees.

The borrower could endure additional financial stress, as they'd be carrying two mortgages plus potentially paying on the bridge loan. If that becomes too much to bear, and they can no longer make payments, lenders could foreclose on both properties. Given those risks, homebuyers should consider all their alternative options first.

What are some alternatives to a bridge loan?

Homebuyers have several options in addition to bridge financing to assist them with the purchase of a new home before listing their existing one. These include:

• Taking out a home equity loan on the current house to finance the down payment on the next one.
• Borrowing against retirement accounts, stocks, bonds, or other assets to help with buying a new home.
• A hybrid mortgage product like an 80-20 mortgage or an 80-10-10 loan. These options enable a homebuyer to take out a second mortgage on the new home to finance the down payment. They can either finance the full 20% down payment on the new home or 10% plus make a 10% cash contribution so that they won't have to pay private mortgage insurance (PMI) on the new home. They then pay off the second mortgage upon closing the sale of their existing home.

Given the costs and risks associated with bridge financing, homebuyers should carefully consider all alternatives, including whether it might make more sense to move into a temporary living situation.