A bridge loan is a short-term loan you can use to make a down payment on a new home. Also known as a swing loan or gap financing, a bridge loan is very useful when you are buying and selling a home at the same time or buying a property at an auction.
You can use a bridge loan to buy another home without making that purchase contingent on selling your existing home first. This might even make your offer more appealing to sellers. Bridge loans also come with higher interest rates than traditional mortgages and additional fees, such as origination charges and a home appraisal.
But there are some scenarios where bridge loans can be very beneficial for your overall financial situation. Let’s look at some bridging loan examples and how they can be used.
How Does a Bridge Loan Work?
There are two ways you can structure a bridge loan.
The first method is to pay off your old mortgage, and put down additional cash for the downpayment for your new home.
For example, your old mortgage is £200,000, and you need £50,000 for the downpayment on your new home. If your current property is worth £500,000, you can take out a bridge loan and pay it off from the home sale proceeds.
Your bridge loan doesn’t require monthly payments. However, the interest is added to your loan balance.
If your income isn’t sufficient to pay two mortgages at once, this is a good alternative. However, bridge loans are expensive come with higher fees, and interest rates of about two percent above comparable prime mortgage rates.
Another scenario of how a bridge loan can be structured is similar to a home equity loan. Rather than replacing the existing mortgage on your old home, you take a smaller bridge loan that just covers the £50,000 downpayment on the new property.
Once you sell your old home, you will pay off your old £200,000 mortgage on top of the £50,000 bridge loan (and accrued interest) from the proceeds.
This is a lower-cost option. However, you must be able to continue paying your old mortgage while also making payments on your new property.
Two key reasons to take out a bridging loan
1. Interest capitalisation
If you don’t have the capacity to cover the repayments on both properties, a bridging loan with an interest capitalisation feature is a suitable solution. This can allow you some financial flexibility while you wait for the sale of your existing property.
2. 100% loan on the new property
A bridging loan lets you borrow up to 100% of the purchase price of your new property, plus the associated costs. This is especially convenient if you’ve purchased a property and are unable to afford the payments. However, the sale of your existing property will change that.
Bridging Loan Example Scenario
Let’s assume that the balance of the mortgage on your existing property is £200,000 and the funds you need for the new property are £500,000. You may be eligible to borrow up to £700,000, which will be your Peak Debt.
This means you will have a short- term debt of £700,000, and will have to pay interest on that while you wait for the sale of your existing property.
If you want to capitalise the interest that accrues on the Peak Debt (provided that your lender offers this feature), the debt will continue to increase until you either start making repayments, or the sale of your existing property is finalised.
For example, let’s assume you’ve been paying the interest and your Peak Debt remains at £700,000.
If the net proceeds of the sale of your current property are £400,000 and you put that full amount towards the Peak Debt, then you will be left with an End Debt of £300,000 (that is £700,000 minus £400,000).
Capitalising repayments
Some lenders offer you the option to capitalise the interest on a bridging loan. This can be a convenient option as you wave the need to make full loan repayments during the bridging period. However, this will increase your Peak Debt each month as the interest is accrued to your loan. This interest is calculated on your Peak Debt, including the capitalised interest that has been added.
Therefore, it is recommended that you make repayments whenever you can to stop the total amount of the loan ballooning and limit the amount of additional interest being charged.
What can You Use a Bridging Loan For?
Example 1 – Buying a House with a Bridging Loan
It is common for people to use bridging loans for funding the purchase of a house. There are several reasons for that:
Speed – A bridging loan can be arranged quicker than a traditional loan or a mortgage, enabling the property purchase to be completed faster. Purchasers using bridging loans are treated as cash buyers and therefore can be favoured above other contenders that need to sell the property first, before proceeding.
An example of where the speed of a transaction is crucial is at a property auction. If you spot a property you want to buy and require access to funds quickly to fund deposit, a bridging loan may be the only option. Other scenarios when the speed of a property transaction is important include; investment purchases or the funding of business ventures, tax bills or divorce settlements.
Flexibility – Bridging loan lenders have different borrowing criteria to high street lenders. That means they are willing to work with potential borrowers with a less than perfect credit score, or self-employed individuals with fluctuating incomes because this type of loan is secured against the property value.
Bridging loans can also be used to break a mortgage chain and give you more flexibility in terms of the timing of further property purchases.
Variety – Bridging loans can be applied against both residential and commercial property types, including building plots without planning permission, therefore providing quick access to funding for a variety of investment opportunities.
Example 2 – Downsizing with the use of a Bridging Loan
Some property owners who want to downsize start house-hunting a long time before selling their current home. Others need funds to renovate or carry out much-needed improvements around their property. Therefore, a bridging loan could finance the gap between the sale of the larger property, to fund the downsized purchase.
Example 3 – Relocation
Many people relocate for a variety of reasons such as a work opportunity or family commitments. However, relocations often come with certain timing constraints that can be challenging. In these circumstances, sometimes you need to buy a new property for the relocation purpose before selling your current one.
A bridging loan can be an ideal solution to finance the move whilst the original property is put on the market.
Conclusion
There are pros and cons of the options available for taking out a bridging loan. It is therefore recommended that you seek advice from an independent mortgage advisor to review the entire situation as well as your personal circumstances.
Specialist brokers often have access to the entire financial market and can therefore provide a wide range of quotes from a wide variety of bridging lenders.
