Bridge Loan

What Is a Bridge Loan?

A Bridge loan is a short-term financing tool used to meet current obligations while long-term financing is being acquired; it is also known as interim financing or gap financing.

It allows the borrower to pay for their current or immediate obligations while they are waiting for their long-term funding. Bridge loans being short-term, have a relatively high interest rate and usually require collateral like real estate or business inventories. 

This type of loan is particularly advantageous for individuals and businesses alike. For prospective homebuyers, bridge loans prove invaluable by facilitating the acquisition of a new residence even before the proceeds from the sale of their previous property materialize. 

While businesses use bridge financing primarily to meet their working capital requirements while waiting for their long-term financing, being a short-term loan, its duration ranges between 6 months to 1 year. 

Bridge loans are sanctioned very fast compared to traditional financing, in fact 57% of bridging loans complete within 1-4 weeks, as the whole point of this type of loan is to cover short-term immediate obligations while the loan term funding is being secure.

How Do Bridge Loans Work?

Individuals use a bridge loan to put a downpayment on the new house while they wait for the funds to arrive from the sale of their old house, as in most cases, a seller will sell the house to whoever pays the downpayment first. 

Once the sale of the old house is finalized, the bridge loan is settled, along with the outstanding payment for the new house.

In this context, a bridge loan is instrumental in reserving the new house from being purchased by another party. When the old house sale is completed, the bridge loan and remaining payment on the new house are paid off. 

These are usually customized based on the borrower's needs, but these loans always come with high-interest rates. They are mostly given to individuals with a high credit score, and in most cases, lenders will offer around 80% of the combined value of both houses as a loan. 

For businesses, this type of loan is used to fund their working capital requirements, and in most cases, the collaterals are the business inventory or business properties. 

For instance, a business has secured equity funding for its expansion project, but to process all these funds and access it, the company will have to wait 3 months. 

So the business has three options in this case, wait for the processing to be completed and then start the work, waste 3 months, or finance the working capital for the three months of the project and pay it back when they can access the equity funds. 

In the second case, the business can take a bridge loan to fund its short-term obligation, allowing it to keep its operation going while waiting for the funds to arrive. 

Types of Bridge Loans

Bridge loans exhibit flexibility in their structure, often tailored to the collateral's quality, repayment certainty, and borrower's specific requirements. These loans can generally be categorized into four types based on their structure.

Closed Bridging Loan

A closed bridging loan is available for a set time period agreed upon by both parties. Lenders are more willing to sanction it since it gives them a fixed time frame of repayments, even if it has lower interest rates than other types of bridging loans.

Open Bridging Loan

An open bridging loan does not have a set repayment time frame at the outset. Because there is no set payoff date, the bridging companies deduct the loan interest from the loan advance to manage their leverage.

Borrowers who are unsure when their expected finance will be accessible prefer an open bridging loan. However, due to the unpredictable repayment timeline, lenders usually impose higher interest rates for this type of loan.

First Charge Bridging Loan

The lender who provides the first charge bridge loan receives their payment before another lender. Even in the case of default, the first-charge lender will get priority in recouping its losses. 

Because of the lower risk level for the first-charge lender, the loan fetches lower interest rates than second-charge bridging loans.

Second Charge Bridging Loan

In the second charge bridging loan, the creditor takes the second charge after the existing first charge lender. They are more likely to default and hence attract a higher interest rate.

Pros and Cons of Bridge Loans

Being a short-term financing vehicle, bridge loans have a lot of cons, but as they provide funding on an urgent basis, we have to acknowledge their pros. 

Pros of Bridge loans.

1. Purchase Flexibility: You can make an offer on a new house without requiring a sale contingency.
2. Smooth Transition: It allows you to purchase a new property before selling your current one.
3. Emergency Funding: It also gives extra funds in the event of an unexpected or time-sensitive transition.
4. Short-Term Solution: It provides a practical short-term alternative for financing your way through uncertain times.
5. Business Continuity: It helps businesses to keep running their operations while waiting for long-term financing. 

Cons of Bridge loans.

1. Equity Requirement: Before extending a bridge loan offer, most lenders demand a homeowner to have at least 20% equity in their house.
2. Higher Costs: It includes higher interest rates and annual percentage rates (APR) than other long-term loans.
3. Emergency Funding: Many financial institutions will only provide you with a bridge loan if you also get your new mortgage from them.
4. Potential Risks: Trouble selling your home might lead to future problems or, in the worst-case situation, foreclosure.
5. Dual Homeownership: You may own two homes at one time, and maintaining two mortgages simultaneously might be burdensome.

Bridge Loan Alternatives

Given the relatively high-interest rates and costs associated with bridge loans, it's prudent to explore alternative financing options before considering them. 

Here are some alternatives that can be considered for short-term financing needs:

Home Equity Line of Credit (HELOC)

A HELOC allows the borrower to borrow against the equity in their present house to cover the purchase of a new home. HELOC interest rates are typically lower than bridge loan interest rates, and the interest is only paid on the amount that was utilized.

401(k) Loan

For people with a 401(k), this loan might serve as an alternative to a bridge loan. However, it is recommended that before obtaining a 401(K) loan, one check with a financial counselor because this might damage a person's retirement savings and have restrictions.

Contingency Clauses

Whenever feasible, pursuing contingency clauses in real estate transactions can be an effective alternative to bridge loans. This clause links the purchase of the new home to the successful sale of your current property.

Family And Friends

If you have a good relationship with friends and family they are in a position to help you by providing you with a short-term loan. Then it is advisable to take their help over any other form of loan where the interest rate will be much higher with strict contracts on repayment. 

But make sure to approach this transparently and put any agreements in writing to avoid misunderstandings with your friends and family.

Researched and authored by Kunal Raj | LinkedIn

Reviewed and edited by Parul Gupta | LinkedIn

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