What Is Bridge Loan And How Does It Work?

Similarly, new businesses can hinder business opportunities due to a lack of funds. Even if you have applied for a large amount of loan, the approval of commercial loans can take time, especially when it is a start-up. The time between the loan application and approval is crucial for businesses as you may lose multiple business opportunities.

In such cases, a bridge loan can help you with your short-term borrowing needs by bridging the financial gap between your instant financial requirement and future possible income.

This article elucidates what a bridge loan is, how it works, and when you should avail of it.

What is a Bridge Loan?

A bridge loan, also known as bridge financing, is a short-term loan used until the borrower secures permanent financing or pays existing dues. It provides immediate cash flow to meet the borrower's short-term obligations.

Notably, bridge loans have relatively high-interest rates and typically require collateral.

While these loans can be availed to meet any short-term cash requirement, they are preferred by homeowners against a current home to buy a new home and businesses against their property/inventory for quick cash. However, note that these loans are not designed to replace traditional mortgage loans like home loans.

Bridge Loans are typically offered for a short period of say, 6 to 12 months and carry a very high-interest rate.

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How does a bridge loan work?

A bridge loan works as gap financing, and it can be availed by individuals as well as businesses.

In case you are a homeowner, bridge loans can help you buy a new home while you are waiting for your current home to sell. You use the equity in your current home for the down payment on purchasing your new home while waiting for your current home to sell.

Lenders mainly consider your credit score and debt-to-income ratio while offering a bridge loan. Since it rolls the mortgages of two properties together, it is a high-risk loan for the lender, which results in ahigh-interest rate. The lenders typically offer up to 80% of the combined value of the two properties. Hence, a borrower requires to have significant home equity in the current property.

In the case of businesses, a bridge loan can help businesses meet their working capital requirements when they are waiting for long-term financing.

What is the difference between bridge loans and traditional mortgage loans?

Bridge Loans are designed to meet short-term fund requirements. Hence, the loan application and approval process is much faster than traditional loans.

Due to the high risk involved and the convenience to get the loan amount almost immediately, these loans carry high-interest rates and processing fees.

Apart from the interest rate and processing fees, there are several other costs involved, such as appraisal fees, administrative fees, notary fees, loan orientation fees, escrow fees, etc.

When should you opt for a bridge loan?

As discussed, homeowners commonly avail themselves of bridge loans to buy a new property while they wait to selltheir current property. They can use a portion of their bridge loan amount to pay off their current mortgage if any, and use the remaining amount as a down payment to purchase a new property.

Here's when it makes sense to avail of a bridge loan for homeowners:

• When you cannot afford the down payment of a new home without selling the current home

• When you want to close the deal on a new home before selling the current home

• When you are not scheduled to close the sale of your current home before closing on the purchase of a new home

• When the seller does not accept an offer contingent on the sale of your current home

• When you are in a seller's market and have chosen a new property

Apart from these situations, businesses can also avail of bridge loans to take advantage of immediate real estate opportunities or to meet their working capital requirements.

Here's when it makes sense to avail of a bridge loan for businesses:

• When you are waiting for long-term financing to get approved/sanctioned and need funds to manage the operating expenses

• When there is a pressing need to acquire a real estate property

• When you want to take advantage of the limited-time offers on inventory and/or other business resources

What are the alternatives to a bridge loan?

While a bridge loan isa great option when you don't have access to a long-term financing solution, it is a costly loan that can make you lose your current property in case you are not able to repay the loan amount within the given timeline. Therefore, considering alternative options before committing to a bridge loan makes sense.

Home Equity Line of Credit:

Home Equity Line of Credit, also known as HELOC, is the most common type of secured Line of Credit. It is secured by the market value of the home minus the amount borrowed. Generally, financial institutions offer credit limits of up to 75% to 80% of the market value of the home after deducting the remaining amount owed on the mortgage. The HELOC is usually offered for 10 to 20 years, during which a borrower can utilise the funds, repay them, and reutilise them.

Home Equity Loan:

Similar to HELOC, a home equity loan is a type of loan in which the borrowers use the equity of their home as collateral. However, unlike HELOC, a home equity loan is a lump sum loan. So, the borrowers get a lump sum loan and have to make fixed monthly repayments within the loan tenure as per the loan agreement.

Business Line of Credit (LOC):

A business line of credit is a type of revolving loan thatprovides a solution to short-term business needs. This financial tool allows access to a fixed amount of capital which can be used to finance working capital requirements, such as purchasing inventory. As the name suggests, businesses can use only the required amount from the total line available and pay interest only for the amount utilised. However, before applying for it, you should check the LOC interest rates, as they can considerably vary across banks and other financial institutions.

To conclude:

A bridge loan can be of great help in case of an urgent need forshort-term finance when you have a permanent borrowing solution. However, the bridge loan interest rate and other fees and charges can make the loan unaffordable and create a huge financial burden. Therefore, before blindly opting for a bridge loan, it is advisable to consider other borrowing options mentioned above and make an informed decision. Apart from taking a loan and putting yourself under a financial burden, it is best to plan for your financial goals in advance. PersonalFN's SMART Fund Explorer can help you plan your mutual fund investments smartly for different goals, such as buying a house, retirement, a child's education, and many more.

Warm Regards,
Ketki Jadhav
Content Writer