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A bridge loan is a temporary form of financing that can help homeowners buy a new home while in the process of selling their current one.
Bridge loans can solve potential problems, but they can be expensive and require a fair amount of equity in your current home. Here's what you need to know before you apply.
What Is a Bridge Loan?
A bridge loan is a short-term transitional loan designed for homebuyers who need to buy before selling their existing home.
If you currently own a home and are looking to buy a new one, the process can be tricky. In an ideal world, you'd sell your current home just in time to use the proceeds to make a down payment on the new one. But if that doesn't happen, the transitional process can become extremely stressful. A bridge loan could help smooth the process.
How Does a Bridge Loan Work?
A bridge loan is a specialized home loan, and like traditional mortgage loans, terms can vary depending on the lender. However, here are some general guidelines for what you can expect from a bridge loan:
- Loan options: There are generally two ways you can use a bridge loan: You can get a small bridge loan and use the funds as a down payment on your new home, or you can get a larger loan, allowing you to make a down payment on the new home and pay off your old mortgage.
- Lender: You'll typically get a bridge loan from the lender that's financing the purchase of your new home.
- Repayment: These short-term loans are designed to be repaid within six to 12 months. You'll typically pay off the loan when you sell your current home, but some lenders require interest-only payments during the loan's term.
- Costs: Interest rates and fees can vary based on current market conditions, the lender and your creditworthiness. In general, though, bridge loans tend to be more expensive than alternatives.
- Collateral: Your current home acts as collateral for the bridge loan. If you default on payments, the lender can foreclose on the home.
Pros and Cons of Bridge Loans
As with other home financing options, bridge loans come with both advantages and disadvantages. Here's what to consider before you apply.
- You can make a stronger offer. Some homebuyers may consider making an offer that's contingent on them selling their existing home. But because these offers create a lot of uncertainty for sellers, they'll be more likely to take an offer from another buyer without the contingency. Even in a buyer's market, sales-contingent offers can be a tough sell. With a bridge loan, you can eliminate the contingency altogether.
- It can help you qualify for a lower interest rate. The higher your down payment on a mortgage, the less risk you pose as a borrower. As a result, you may qualify for a lower interest rate. If you have a lot of equity locked up in your current home, you can use a bridge loan to tap some of those funds to provide a larger down payment and save more in the long run. If you can put 20% or more down on the new home with a conventional loan, it can also eliminate the need for private mortgage insurance.
- You don't have to move twice. While selling your old home before closing on the new one eliminates the need for a bridge loan, you may be required to find temporary housing until you can close on the new home. A bridge loan simplifies the process and can get you into the new home directly without requiring you to move twice.
- It can be expensive. Between fees and high interest rates, a bridge loan can be more expensive than alternatives, including a home equity loan. What's more, you may end up with two mortgage payments for a time, which can put a strain on your budget. If you can't keep up with your payments, the lender can foreclose on your old home, creating more financial distress.
- It's not easy to qualify. Bridge loans tend to be riskier for lenders than traditional mortgage loans, so they tend to come with more stringent credit requirements for those who apply.
- You may not get enough. You'll typically need a significant amount of equity in your current home to borrow what you need while meeting the lender's maximum loan-to-value ratio requirements.
Bridge Loan Requirements
As with traditional mortgage loans, the requirements to get approved for a bridge loan can vary by lender. That said, here are some guidelines:
- Minimum credit score: In many cases, you can expect to need a credit score of 700 or higher to get approved, though some lenders may go higher or lower than that.
- Maximum debt-to-income ratio: Some lenders allow your debt-to-income ratio—the percentage of your gross monthly income that goes toward debt payments—to go as high as 50%. But because you're generally adding a sizable amount of debt on top of your existing mortgage payment, as well as a new mortgage payment, it can be difficult to stay under that threshold.
- Loan-to-value ratio: Bridge loan lenders typically offer loans of up to a combined loan-to-value ratio of 80%. In other words, your current mortgage loan and the bridge loan amounts cannot total more than 80% of the home's fair market value. If your loan-to-value ratio is already above 80% or it's not far below it, you may not get the money you need.
And remember, lenders typically won't provide a bridge loan unless you're planning to use them to finance the new home purchase. Not all home lenders offer bridge loans, so your options may be limited.
When Could a Bridge Loan Be a Good Option?
There are a handful of situations where it can make sense to consider a bridge loan to create a smooth transition from one home to another. Here are just a few examples:
- You're in a time-sensitive situation that makes it difficult or even impossible to sell your existing home before buying a new one.
- You can't afford a big enough down payment without the equity you have in your current home.
- You're in a seller's market and need the strongest offer possible.
- Sellers in the area you're looking to buy don't accept contingent offers.
- You anticipate selling your current home within the next few months.
- You want to avoid moving twice or feeling stuck in limbo with a temporary housing situation.
Even in those situations, though, take some time to research and compare some alternatives before you commit to a costly bridge loan.
Alternatives to Bridge Loans
If you're concerned about the high cost and risks associated with a short-term bridge loan, here are some other options to consider:
- Home equity loan: A home equity loan is also based on the equity you have in your home but has a few advantages over a bridge loan, including lower interest rates, lower loan costs and longer repayment terms.
- Home equity line of credit: A home equity line of credit (HELOC) is similar to a home equity loan but provides a revolving line of credit instead of a lump-sum loan with installment payments. HELOCs typically require interest-only payments during the initial draw period, helping you avoid a large second monthly payment. However, interest rates are typically variable and can increase over time, which can cause problems if you don't pay back the debt quickly. Also, some lenders charge a prepayment penalty if you close a HELOC early.
- Piggyback loan: If you have enough cash on hand to make a 10% down payment on your new home, a piggyback loan—also called an 80-10-10 loan—can help you get to an 80% loan-to-value ratio and avoid private mortgage insurance. With this loan, you get a first mortgage for 80% of the sales price of the home and a second loan for 10% of the sales price, leaving the final 10% coming from your cash reserves.
- Sell your home with a contingency: Just as buyers can make an offer with a contingency, sellers can do something similar. For example, you can make the sale of your existing home contingent on you finding a new home, or you can request to rent back the home for a set period, giving you more time to find and close on a new home. Both contingency options can potentially help the transition process go more smoothly. But if it's a buyer's market, you may have a hard time convincing anyone to agree to them.
Take Your Time to Make a Decision
Even if your situation demands a quick transition, avoid the urge to make a decision without carefully considering all of your options. Check your credit score to see where you stand and what you can reasonably qualify for, then run the numbers on each potential path for your specific situation to determine which one is the best option for you.