A bridge loan is a type of loan that covers the difference between the purchase of a new home and the sale of a borrower’s current home
What is a bridge loan?
A bridge loan, which is also known as a swing loan, is a short-term temporary loan that is usually up to one year long. It “bridges” the gap between the time it takes a borrower to purchase their new property before they sell their current property.
This is a secured loan that requires some form of collateral which is usually your existing home. It provides immediate funds but also comes with high-interest rates (on average 2% higher than conventional 30-year fixed-rate mortgages) and more substantial origination fees (in general over 1% of the outstanding loan balance). On the other hand, bridge loans typically have a faster application and approval process as compared to a traditional mortgage.
Borrowers usually must have a significant amount of home equity in the original property because most lenders only consider a maximum 80% loan-to-value ratio. In other words, you will need to have at least 20% equity in your current home to qualify for a bridge loan.
How does it work?
In the mortgage industry, there are two types of bridge loans.
The first type is when you borrow enough money required to pay off your first mortgage and the down payment on your new home. In this scenario, you no longer need to make any more monthly payments on the old mortgage but only pay the interest payments on the bridge loan. When your old home sells, you are then able to pay off the loan’s principal balance and the accrued interest.
For example, let’s say your current home has a value of $200,000. The remaining amount on your mortgage is $100,000. You may take out a bridge loan that is equivalent to 80% of your home’s value, or $160,000. This loan allows you to pay off the outstanding balance on your first mortgage as well as put the $60,000 towards closing costs and a down payment.
Alternatively, the second type is when you borrow against the equity you have in your first home. In this scenario, you maintain your first mortgage but use the equity to provide the down payment on your new house. After you receive the funds from the sale of your first home, you can pay off the bridge loan.
Using the same example, if your current home as a value of $200,000 and a remaining mortgage of $100,000, you have $100,000 in equity. A bridge loan on 80% of your equity is $80,000. As a result, you have $80,000 that can go towards your closing costs and the down payment of your next home.
Benefits of Bridge Loans
Using a bridge loan helps you avoid making a sale-contingent offer. This contingency allows you to back out of the contract if your current home does not sell. A sale-contingent offer does not make you an attractive homebuyer.
Limitations of Bridge Loans
The benefits of a bridge loan come at a cost. You will likely pay higher interest rates and APR as well as temporarily own two houses for a time. Depending on your bridge loan, this may also require paying two mortgage payments until you sell your first house.