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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.
In other words, it can bridge the gap that can occur when you're transitioning from one mortgage to another without requiring you to sell your current home first and live in temporary housing or make an offer on the new home contingent upon your ability to sell the old 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.
How Bridge Loans Work
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—unless you get a bridge loan.
A bridge loan is a short-term loan—repayment terms are typically less than 12 months—that can provide you with the cash you need to buy your new home whether or not you've managed to complete the sale of your old one. Here's how the process might work:
- Gain access to the equity in your current home through a bridge loan.
- Make a down payment on your new home using the proceeds from the loan.
- Sell the old home and use the profit from the sale to pay off the bridge loan.
With a bridge loan, you can typically qualify for up to 80% of the loan-to-value ratio of your current home. So if you don't have at least 20% equity, you may not qualify right off the bat. If you do, but just barely, you may not get enough proceeds from the loan to make it worth your while.
Bridge loans typically charge high interest rates compared with other home equity financing options, primarily because they're short-term loans. As a result, you may get an interest rate that's a few percentage points higher than on a conventional mortgage or home equity loan. Fees can also be relatively high, increasing the total cost of credit.
Finally, bridge loan lenders tend to have high eligibility criteria, both in terms of credit and debt-to-income ratios, especially if there's a chance you'll have two mortgage payments for a while.
Benefits and Downsides of Bridge Loans
There are both advantages and disadvantages of using a bridge loan you make transitioning to a new home go more smoothly. Here's what to consider.
- You don't have to move twice: If you sell your old home before closing on the new one, you'll likely need to find temporary housing until you complete the process. A bridge loan simplifies the process and can get you into the new home directly.
- You can make a stronger offer: An alternative to using a bridge loan is making a contingent offer on a new house. This means that your offer to buy is contingent upon you selling your current home. Unfortunately, these offers make for a lot of uncertainty for sellers, so they'll be more likely to take an offer from another buyer without the contingency. If you have 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 such, you may qualify for a lower interest rate if you can provide a big down payment. If your current home isn't sold yet, a bridge loan can give you that high down payment and potentially a lower interest rate.
- It can be expensive: Between fees and high interest rates, a bridge loan can be more expensive than alternatives, including a home equity loan.
- It's not easy to qualify for: Because you're not selling your current home yet, you may be making two mortgage payments for at least a month or two, and possibly longer. With that kind of debt burden, bridge loan lenders may have strict credit and debt-to-income ratio requirements for those who apply.
- You may not get enough: Bridge loan lenders typically offer loans of up to a combined loan-to-value ratio of 80%. This means that your current mortgage loan and the bridge loan 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, making it an unnecessary expense.
When to Use a Bridge Loan
Considering both the perks and pitfalls of using a bridge loan, there are some clear situations where it may or may not be good to apply for one.
Specifically, a bridge loan may be a good idea when:
- You qualify based on creditworthiness and equity requirements.
- 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.
On the flip side, a bridge loan may not be worth it if:
- You can qualify for a lower interest rate with a home equity loan.
- You're not sure when you're going to be able to sell your current home.
- You don't need a bridge loan to make a sufficient down payment on your new home.
- You're not sure you can handle making two mortgage payments simultaneously and have a bridge loan on top of them.
- You're in a buyer's market where contingent offers are acceptable and expected.
- You've managed to time things perfectly to sell your current home and use the sales proceeds to buy the new home.
Credit Score Needed for a Bridge Loan
There's no hard and fast rule for what your credit score needs to be to get approved for a bridge loan—all lenders have varying creditworthiness criteria. That said, you can generally expect lenders to require a credit score that's considered good or excellent to get approved.
Also, you'll likely need a low debt-to-income ratio to prove your ability to manage two mortgages and a bridge loan for a short period. For reference, many mortgage lenders want to see your monthly housing costs for one mortgage to be 28% of your gross monthly income or less. If your ratio is around that figure on your current home, you may have a hard time getting a bridge loan.
Alternatives to a Bridge Loan
If you're on the fence about whether a bridge loan is right for you, there are a couple of alternatives to compare it with before you make a decision.
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 charge variable interest rates that are even lower than what you can get with a home equity loan, which may be perfect if you're planning to pay back the debt quickly.
Just keep in mind that some HELOCs charge a prepayment penalty if you pay off the balance early.
If you have enough cash on hand to make a 10% down payment on your new home, this 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.
It's not ideal to get started in your new home with two loans, but it can be less expensive and less stressful than a short-term bridge loan.
Sell Your Home With a Contingency
Just as buyers can make an offer with a contingency, sellers can do something similar. One option is the "home of choice" contingency, which means the sale of your current home to a buyer is contingent upon you finding a new home to purchase.
The second one is a "rent back" contingency, which allows the sale to go through with the provision that you can rent the home from the buyer for a set period while you complete the buying process on a new home.
Both of these contingencies 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
Whether you opt for a bridge loan or one of the suggested alternatives, it's important to take your time before pulling the trigger on any of them. Check your credit score to see where you stand and what you can reasonably qualify for, then run the numbers on each for your specific situation to determine which one is the best option for you.