A bridge loan (sometimes referred to as a swing loan, gap financing, or interim financing) is a temporary financing option that businesses and individuals use to “bridge the gap” between times when funding is needed but not yet available — in other words, it’s a loan to help meet your immediate cash flow needs.
When it comes to real estate, bridge loans allow homebuyers to purchase a new home while waiting for their current home to sell. On the other hand, companies might use bridge loans to pay off current obligations as they get a long-term loan.
Bridge loans offer a solution for homebuyers to get the home they want without putting in more money. Similarly, funding from bridge loans helps businesses stay afloat or take advantage of profitable opportunities while waiting for long-term financing.
In this article, we discuss everything you need to know about bridge loans. Keep reading to find out how it works, what you need to qualify, and why it’s different from other traditional loans you know.
How Do Bridge Loans Work?
A bridge loan typically serves as a temporary source of financing while a business or a person secures a more permanent solution, like equity financing or a long-term, low-interest loan.
This is why bridge loans have short repayment terms. On average, most loans are payable within six months to a year.
For real estate transactions, bridge financing allows homebuyers to borrow against a portion of their current home’s equity to make a down payment on a new home. Essentially, borrowers can take out a loan equal to their home equity. Home equity is calculated as the value of the home minus the homeowner’s balance on their mortgage.
Bridge loans are commonly offered by online lenders, local banks, credit unions, and hard money lenders. So, homeowners needing this type of loan may not always get funding from traditional mortgage lenders.
In addition, bridge loans usually have higher interest rates than other financing options, like home equity lines of credit (HELOC).
Qualifying for a mortgage comes with some conditions as well. These conditions may include paying off existing debts, such as car loans or HELOCs. That’s why, in some cases, taking out a bridge loan is the best option for homeowners, especially in the following scenarios:
- If it’s a seller’s market where the borrower wants to make sure they get the house they’ve chosen and are confident they can sell their current house quickly
- If the borrower wants to buy another home without making the purchase conditional on selling their existing home — it makes the offer more appealing to sellers
- If the borrower can’t afford a down payment on the new home without selling their existing property first
- If the borrower is scheduled to close on the purchase of the new property before closing on the sale of their old home
With bridge financing, the mortgage for the existing property and the new house are rolled together. And the homeowner only pays for the loan while it’s in place.
However, homebuyers should note that they must sell their home within the brief loan term. Otherwise, they’ll have to make payments on both mortgages plus the bridge loan. So, make sure to properly assess the market and consult with professionals if necessary.
Meanwhile, businesses need capital to start, run, and grow. Business owners raise capital mostly through their own savings, borrowing from family and friends, equity financing, and small business loans. Equity financing refers to the process of taking investments from private investors or selling shares to the public to raise capital.
In this regard, businesses use bridge loans to:
- Cover operating expenses, such as wages and salaries, rent, and inventory until the funding from investors or long-term loan goes through
- Buy land or a building for business use quickly while waiting for financing
- Take advantage of profitable business opportunities, such as savings for a bulk purchase of inventory
An Example of a Bridge Loan Being Used
In an ideal situation, homeowners buying a new property would like to close the sale of their existing residence and get in their new home within the same period. This is because homebuyers typically use the proceeds from the sale to cover the expenses they incur on the purchase of a new property.
But when things don’t go as planned, bridge loans enable homebuyers to purchase a new home before their current home sells. In this case, the homeowner takes out a bridge loan to use as a down payment.
It’s an additional cost, but the loan helps the borrower purchase the house they want and gives them extra time and flexibility to sell their old home. Then, when the first home is sold, the proceeds pay off the bridge loan.
Businesses use bridge loans in the same way as homebuyers. Taking on investors, selling shares, and applying for long-term loans take time. But companies need capital every day to run their operations. So, during a bout of equity financing where they expect funding to be issued in less than a year, businesses might take out a bridge loan.
The funding from the loan pays for day-to-day business expenses while they’re waiting for financing from investors. Similarly, while they’re setting up a long-term loan, companies use the temporary cash from bridge loans to cover any gaps in cash flow as they finalize the terms of a long-term form of funding.
How Do You Qualify for a Bridge Loan?
Eligibility requirements vary depending on the lender and the type of loan. If you’re looking to get approved for a bridge loan, lenders usually consider your personal credit score, your debt-to-income ratio, and how much equity you have in your existing property.
Note that the loan is also secured by your current home. Even though a bridge loan is a short-term loan, there are several things to consider. So, take your time and understand how the requirements affect your application.
Credit Score
Your personal credit score measures your creditworthiness based on your credit history. It helps lenders determine how likely you are to repay a loan and how responsible you’ve been with your credit in the past. It’s calculated based on the total debt you have, the length of your credit history, payment history, and the types of debts you’ve taken out.
Credit scores range from 300 to 850. And the higher your score, the better. Individuals with higher credit scores get approved for most loans they apply for and may get lower interest rates and better repayment terms. Bridge loan lenders typically ask for good to excellent credit scores, which translates to 670 or above.
Debt-to-Income Ratio
Your debt-to-income ratio (DTI) calculates what portion of your income each month goes toward your fixed expenses and debts. Expenses and debts commonly include a mortgage, car loans, credit card debt, insurance and health care premiums, utilities, and other debts.
Essentially, a DTI ratio compares how much you owe to how much you earn before taxes. Lenders look at your debt-to-income ratio to assess whether you can afford to make multiple loan payments. They want to make sure that you have enough income to manage payments for the bridge loan, your current mortgage, and the mortgage for the new home if needed.
Lenders generally want DTI ratios to be around 36% or less. Some mortgage lenders may approve borrowers with ratios of 43%, but that’s the highest they’ll typically go.
Equity on Your Current Home
Since you’re borrowing against your current home’s equity, you need a decent amount of equity to qualify for a bridge loan. This is why you’ll find that most lenders require at least 20% home equity before they approve a bridge loan application.
It helps if you have a credit history with the mortgage lender and you’ve kept up with your mortgage payments in the past. If you have a good relationship with the lender, you might be in a good position to ask for a bridge loan and be approved for it.
Collateral
When getting a bridge loan, make sure to read your contract. Understand the terms in case the sale of your existing property falls through. Bridge loans are secured loans, and the homeowner’s current home is the collateral.
It means the lender could foreclose on the property if the homeowner runs into trouble selling it and the bridge loan expires. That’s why you have to assess the market and consider your options before getting a bridge loan.
Pros and Cons of Bridge Loans
In this section, we discuss the pros and cons of bridge loans to help you consider if it’s the right type of financing option for you.
Pros of bridge loans
- It provides a fast and easy source of funding for businesses that are awaiting capital from another form of long-term financing.
- It allows homebuyers to purchase a new property even before selling their current home.
- It offers flexibility and peace of mind for business owners and homeowners to have cash available when they need it.
- It provides working capital to businesses during periods of time-sensitive transitions.
Cons of bridge loans
- It comes with higher interest rates and fees than small business financing or other personal loan options, such as business lines of credit, term loans, home equity loans, etc.
- It can cause a financial burden to homebuyers who may need to pay the interest plus two mortgage loans.
- The cost of debt and interest payments could impact a business’s cash flow negatively.
- It has more strict requirements than other financing options, so it can be difficult to qualify for.
- Since bridge loans are customized to the borrower, the terms, costs, and conditions can vary widely.
- Borrowers have to put up collateral, such as property or inventory, to get approved for a bridge loan. The collateral can be foreclosed or seized when the loan expires.
How Are Bridge Loans Different From Traditional Loans?
A bridge loan is a short-term financing option by design. So, the application, approval, and funding process is faster compared to many traditional loans. In return, bridge loans have short terms with little to no extension periods or refinancing options. Plus, they come with high interest rates and additional legal and administrative fees.
In addition, the terms, costs, and conditions associated with bridge loans vary widely across lenders. Regardless of the terms, bridge loans offer convenience and flexibility. That’s why many borrowers still use it as a form of financing.
In contrast, traditional loans are designed to offer financing solutions to individuals and business owners. The terms, interest rates, and requirements of available traditional loans vary. But, in general, they offer a wide array of funding options for borrowers to choose from depending on their financial or business needs.
What Are Typical Interest Rates on Bridge Loans?
As we’ve established, bridge loans come with higher rates. Your creditworthiness and the loan amount also affect the rates you get approved for.
On average, interest rates for bridge loans start from the prime rate, which is currently at 5.50%. Depending on their credit scores, borrowers may pay around 8.5% to 10.5% interest.
For business bridge loans, the rates are even higher at 15% to 24%.
Borrowers should also be prepared to pay additional fees, such as application fees, appraisal fees, and escrow fees. You’ll be responsible for underwriting fees, origination fees, notary fees, and title insurance fees as well.
All in all, these closing costs and fees could add 1.5% to 3% to the loan amount. This is why it’s recommended that you review the terms before you agree to a bridge loan.
What Could Prevent You From Qualifying for a Bridge Loan?
Lenders consider your personal credit score, debt-to-income ratio, and the amount of equity you have in your home before they approve you for a bridge loan. Typically, they’re looking for a good to excellent credit score and a low debt-to-income ratio.
The higher your credit score, the better chances and interest rates you’re going to get. Meanwhile, a low debt-to-income ratio means you have enough income to afford additional monthly payments if they extend the loan to you.
In addition, lenders also require that you have at least 20% equity built up in your current home to be approved for a bridge loan. This is because you are borrowing against the equity on your home, and you’re putting your home as collateral for the loan.
If your finances and equity don’t meet these requirements, your mortgage lender may ask for additional documents before you get approved. But it’s also a good idea to ask for recommendations from a mortgage broker or loan specialist on the best course of action before you apply.
How to Get a Small Business Bridge Loan
With the wide array of available financing options in the market, there’s a solution for every funding need. A bridge loan offers such a solution to homebuyers and entrepreneurs in need of a fast and easy funding option.
If you’re interested in applying for a bridge loan for your small business and want a knowledgeable person to guide you, contact Clarify Capital today and speak to our dedicated advisors.
If you’re looking for alternative funding options, speak to a Clarify advisor. We work with more than 75 lenders to help you find the best rates and loans for your business needs.