Are you asking yourself, “How does a bridge loan work?” A bridge loan, or swing loan, provides borrowers and businesses with a lump sum while they attempt to secure more substantial or long-term permanent financing.
What Can I Use a Bridge Loan For?
Consumers use bridge loans to afford the cost of various purchases while they make the transition between two transactions. For example, a homeowner may need money for closing costs or a down payment during a real estate transaction. That homeowner may be able to use bridge loans, offered by hard money lenders to finance short-term expenses and invest in real estate opportunities.
Lenders that offer bridge loans typically allow eligible borrowers to finance up to 80% of the combined value of the new home and the one being sold. Suppose you are selling a home for $150,000 and buying a new one for $250,000. In that case, you may be able to obtain a bridge loan worth up to $320,000. But remember that the amount you qualify to receive depends on your financial background.
Once a bridge loan borrower pays off the outstanding balance, they can apply for a traditional mortgage loan that has a more favorable interest rate and longer repayment length.
How Does the Repayment Process Work for Bridge Loans?
A bridge loan generally lasts between three months and one year, although the loan terms depend on the lender you work with. Certain banks and credit unions offer bridge loans, but you may also be able to work with a private online lender.
The payment structure of a bridge loan depends on the financial contract you sign with a lender. While most financial institutions accept repayment through monthly installments, some lenders prefer a single lump sum payment. Consider the repayment schedule you prefer when looking for a bridge loan.
If you prefer the installment repayment method, consider how much time you want to repay the bridge loan. An extended repayment period will usually result in lower monthly payments, but keep in mind that you also push back the final due date. A long repayment plan will increase the overall cost of the loan. That being said, short-term loans can also be expensive due to high-interest rates. When looking for a bridge loan, take time to compare multiple lenders and repayment terms.
What Are the Interest Rates on Bridge Loans?
The interest rate on a bridge loan depends on your financial background, whether you use collateral and the lender you work with. However, bridge loan interest rates generally range from 6% to 16%.
Low-credit borrowers typically get higher rates because lenders consider them financially risky to work with. But if your credit score is higher, you may be able to secure a low-interest rate. Remember that you do not need perfect credit to find a good loan offer. You can find the best rate for your budget by inquiring with multiple lenders and comparing rates.
Is Using a Bridge Loan a Wise Financial Decision?
Most borrowers use bridge loans to afford the cost of buying a new home while they sell their current one. While it may be easier to wait until a current home is sold before starting the home-buying process, this may not always be the best option.
In this real estate market, properties come and go extremely quickly. It’s not unusual for real estate properties to come on the market and be gone just as quickly. If you love a house that was just listed, know that many real estate agents recommend putting in an offer right away to avoid losing out on a dream home.
To decide whether a bridge loan is the right financial decision for you, there are various factors to consider. If you are thinking about applying for bridge loans, ask yourself the following questions:
- How much money do you need?
- When do you want to repay the bridge loan?
- What is the maximum monthly payment amount you can afford?
Once you start inquiring with bridge loan lenders, pay attention to the interest rates offered. Higher rates can increase the overall cost of the loan and result in higher monthly payments. Comparing lenders and repayment terms helps you find the best offer for your unique financial situation.
Eligibility Requirements for Bridge Loans
Wondering about the eligibility requirements for a bridge loan? While every financial institution has its own list of qualifying requirements, most lenders still analyze the same factors.
These are the financial categories that lenders generally consider during the approval process for bridge loans:
Income and Employment
Income is one of the most important qualifying factors for bridge loans. A financial institution needs to verify your ability to repay the bridge loan. Your employment history and gross monthly income will be scrutinized during the approval process. The amount you can get through a bridge loan is directly correlated to how much you earn and are capable of repaying.
Most bridge loan borrowers provide weekly or biweekly paycheck stubs. However, not everyone receives consistent payments. For example, self-employed individuals may receive income sporadically. The good news is that financial institutions typically have a list of multiple acceptable income documents.
You may be able to use the following documentation as proof of income for bridge loans:
- Bank statements.
- Tax documents (W2, 1099-NEC, 1099-MISC, etc.)
- Invoice documentation.
- Social Security benefit statements.
- Workers’ compensation letter.
Creditworthiness
Your creditworthiness can directly affect your qualification status for a bridge loan. Creditworthiness is a person’s ability to repay their outstanding debt and is represented by a three-digit number calculated by a credit scoring model. Most lenders refer to the FICO scoring model when making qualifying decisions. A FICO score ranges from 300 to 850 points, and scores are split into five categories.
These are the five categories of FICO scores:
- Poor (300 to 579)
- Fair (580 to 669)
- Good (670 to 739)
- Very Good (740 to 799)
- Excellent (800 to 850)
A high credit score indicates that a consumer is financially responsible and capable of managing debt. However, you do not need a perfect score of 850 points to be eligible for a bridge loan. Every lender has a different minimum credit score requirement, so it’s possible to find a loan offer with fair or poor credit. But remember that lower scores tend to get higher interest rate offers.
Borrowers can save on interest rate fees by making additional payments every month or increasing the monthly payment amount. But before you change your final payment date, ensure the lender does not charge prepayment penalty fees. Prepayment penalties are penalty charges for shortening the repayment schedule to avoid paying interest fees.
DTI Ratio
A debt-to-income (DTI) ratio is a percentage that represents the portion of your income that goes toward repaying outstanding debt. Having too much debt can negatively affect your credit score because it is a sign of financial instability. Financial institutions generally consider having a DTI ratio that exceeds 43% to be high. But remember that every lender is different, and some may have more strict DTI requirements.
To calculate your DTI ratio, you need to know your gross monthly income and your total monthly expenses. Divide the amount of your debt by your income to get your DTI ratio as a decimal, which you can convert into a percentage. Suppose you earn $3,000 monthly and spend $1,000 monthly on debt repayment. In that case, your DTI ratio would be 33%.
However, there are two types of DTI: front-end and back-end.
- Front-End DTI — The front-end DTI ratio is also known as the housing ratio because it uses housing-related expenses. Front-end DTI includes expenses such as rent, mortgage payments, and private mortgage insurance (PMI).
- Back-End DTI — The back-end DTI ratio is also known as the debt-to-income ratio because it uses a borrower’s total monthly debt payments. Back-end DTI expenses include credit card debt, student loans, payday loans, and auto loans.
Your DTI ratio will change depending on whether a lender uses front-end DTI, back-end DTI, or both. It’s in your eBay interest to keep both DTI ratios low by maintaining a low debt amount.
Collateral
Collateral is an item used as security for debt repayment. If a borrower defaults on their loan, then the lender has the legal right to claim ownership of the item. Loans that require collateral, such as bridge loans, are known as secured loans.
The type of collateral you can use depends on the type of loan you apply for and the lender. However, these are a few common items that borrowers use as collateral:
- Certificates of title (car, boat, etc.)
- Cash in a savings account.
- Cash held in a certificate of deposit (CD) account.
- An investment account or product (stocks, bonds, etc.)
Financial experts often advise consumers to avoid secured loans because they are financially risky. In the event you experience financial issues during the repayment process, you can lose your personal property. For example, you lose possession of your home if you use it to get a bridge loan. This is one of the main disadvantages of bridge loans, so carefully consider whether you are willing to use collateral to get gap financing.
Bridge Loan Alternatives
While bridge loans are useful financial products, there are disadvantages to consider. But what are the cons of bridge loans? Bridge loans typically have higher interest rates than traditional loans, and most lenders expect collateral to secure funding.
If you are interested in bridge loan alternatives, take a look at a few traditional loan options below:
Home Equity Line of Credit
A home equity line of credit (HELOC) is a form of revolving credit because borrowers receive an “open-end” line of credit. HELOCs work like credit cards. Once a borrower repays a portion of the principal balance, they can borrow that amount again. HELOCs can have a short or long repayment period that lasts several years.
In order to qualify for this financial product, a homeowner must use the equity in their home as collateral. The property must have a specific amount of equity, such as 15% or 20%. Every lender has a minimum equity requirement, so if you have a low equity amount, you may have to inquire with multiple lenders.
In addition to equity, borrowers are typically expected to have a decent credit score and a low DTI ratio. The qualification requirements for a HELOC are generally strict, but the repayment terms can be decent. The biggest advantage is that borrowers have more time for repayment than with a bridge loan. But be prepared to go through a lengthy approval process.
Personal Loan
A personal loan is a versatile installment loan that borrowers can use for various emergency expenses. Borrowers repay the loan through monthly payments for a designated period. Personal loans can provide short or long-term financing, which allows you to pick the best financial plan for your budget.
Banks, credit unions, and online lenders provide personal loans. Eligible applicants must have a reliable source of income and a decent credit score to qualify. However, many lenders offer bad credit personal loans that have flexible credit requirements. The loan amount for a personal loan varies by lender, but it may be possible to get up to a few thousand dollars in emergency financial assistance.
Home Equity Loan
A home equity loan is a loan secured by the borrower’s home, which is why lenders refer to it as a second mortgage. The loan amount a homeowner can get depends on the market value of their home, credit history, and income. Home loans are repaid in monthly installments for a predetermined period.
Home loans can provide a lot of money because the collateral, your home, is typically very valuable. However, the approval process can take several weeks or months. There is a lot of documentation that must be completed, and the lender will generally require an appraisal of the property.
Remember that home loans are secured loans, and they can be risky. If the borrower cannot meet the repayment obligations of their financial contract, they can lose possession of their home. Before applying for this type of loan, talk to your potential lender about the default process.
The Bottom Line: Bridge Loan
A bridging loan, also known as bridge financing, is a secured short-term loan that provides temporary financing until a person or company secures permanent financing. Borrowers can use their bridge loan to afford closing costs or the down payment of a new home. While bridge loans can be useful financial products, there are alternative options to consider. It’s crucial for consumers to explore all of their options before making a decision to borrow funds.
References:
What Is a Bridge Loan?│Realtor
What is a good debt-to-income ratio for a mortgage?│New York Post
Home Equity Loans and Home Equity Lines of Credit│Federal Trade Commission