If you’re looking to buy a piece of residential property or invest in real estate, a bridge loan, or ‘bridging loan’ can be a good financing option. However, as with most financing options, there are pros and cons to consider.
What is a bridging loan?
A bridge loan is a short-term financing option whose term may last anywhere between 2 weeks and 3 years. With that said, most bridge loans typically last between 6 and 12 months. Homeowners tend to choose bridge loans for closing a property deal, either for the sake of investment or to buy another piece of property while they wait for the current one to be sold.
How does a bridge loan work?
Bridge loans generally work along the same lines as a traditional mortgage. For example, you will need to have some equity in the property to be bought. So, assuming your home is worth £400,000 but still has, perhaps, £250,000 left on the mortgage, your equity would be £150,000. Since the loan needs to be backed by some kind of collateral, it’s important to always have access to this equity.
Now, are there drawbacks to taking a bridging loan? Sure, there are:
Not everyone is a good candidate for bridge financing because the equity you have in your current property needs to be reasonably high. This is necessary to ensure that once financing for the new property has been secured, there is still a reasonable amount of equity across both properties. In the example above, the £150,000 amount may not be sufficient. So, the combined loan-to-value ratio across both properties needs to be reasonably high and acceptable to the lender.
Bridge loans tend to have exceedingly short lifespans, which means a fair amount of work is required on the lender’s part. This explains why the loans are so high-interest: typically between 8.5% and 10.5% of the full loan amount. Plus, the closing costs and other fees pertaining to the loan can be quite high, driving overall costs up. Most lenders charge fees to value both your existing and current property, along with other application costs.
You must deal with the burden of servicing a higher debt as you’re going to be paying off two mortgages. Even though some bridge financing products let you ‘freeze’ the repayments (so you only repay the current mortgage), the bridging loan interest accrues on a monthly basis. This adds to the total loan amount; the longer you take to sell the current property, the bigger the loan, debt, and interest. Should you not sell according to the bridging loan terms or don’t get the target sale price, things can take a turn for the worse pretty quickly.
Are there upsides to a bridge loan?
Definitely! Bridge financing can be arranged very quickly compared to other financing options. With no regulatory burden to worry about, lenders are very agile, swift, and cooperative in how quickly they can help you free up funds.
The loans are often paid back on a ‘retained interest’ principle, which is a simpler and more affordable option for individuals or companies that have ongoing cash flow problems.
As long as you have sufficient security in place, the loans can be arranged for 100%, and there are no expensive exit fees to worry about in the event of early repayment.
Ultimately, bridge loans are a really good short-term financing option to bridge the gap between two financial transactions, as long as you’re confident that your current property will be sold within the next few months.
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