Bridge loans, a type of gap financing, provide a powerful tool when purchasing a home. Many times, home buyers need to sell one home to buy the next.
However, homes don’t always sell as quickly as we’d like. A bridge loan can help you get into your new home without having to sell your old home below market just to turn the sale quickly.
One key to qualifying, though, hinges on the amount of equity you have in your home. Here’s what you’ll need to know if you’re considering a bridge loan.
What is a bridge loan?
A bridge loan is a short-term loan that uses the equity you’ve built to help you purchase a new home before you sell your old home.
You’ll sometimes see bridge loans referred to as gap loans, swing loans, or gap financing. These terms aren’t always interchangeable, though. In some contexts, they can differ, particularly for investment properties.
The various nicknames for this type of loan offer a better understanding of what bridge loans do, however. A bridge loan bridges the gap when buying a new home requires the equity you’ve built in your old home.
How does a bridge loan work?
Residential bridge loans
In a residential bridge loan, the bridge loan becomes a first or second mortgage. Which of these paths the loan takes can depend on whether you already have a mortgage.
Even with a paid-off mortgage, buyers may need to access the equity in their home to purchase a new home. A residential bridge loan becomes the new mortgage — or second mortgage if the house is already mortgaged.
You can then use the funds from the bridge loan to help purchase your new home. In most cases, residential bridge loans offer a 6-12 month loan term. This gives you time to sell the old home.
Commercial bridge loans
A commercial bridge loan offers similar flexibility to residential bridge loans. But the way you qualify may differ. Where residential bridge loans base eligibility on equity on your home, commercial bridge loans may use other properties as collateral.
Commercial bridge loans provide a way to move quickly on an opportunity. Long-term financing, like a mortgage, typically replaces the bridge loan in a matter of months.
Based on condition, some investment properties may not qualify for a mortgage right away. A bridge loan can also provide the money needed to rehab the property. Afterwards, you may have more financing options.
When to get a bridge loan
Let’s say you need to move to another area for work. You already own a home but you’d like to purchase a new home in the new city.
In some markets, a home sale can take months, particularly if you don’t want to drop your price. This creates a challenge if you want to buy quickly in the new city but need to use the equity from your old home.
Here’s an example of how the process might work.
You expect to sell your old home for $400,000. You have $150,000 in equity, meaning you still owe $250,000.
In most cases, you’ll need at least 20% equity in your home to qualify. In this example, with 37.5%, you have enough equity.
With a bridge loan, you may qualify for up to 80% of your home’s value. In this case, that’s $320,000. You owe $250,000.
Closing costs for the bridge loan might run another $6,000. After paying off the original mortgage, the bridge loan gives you about $64,000 you can use as a down payment.
How to qualify for a bridge loan
Much like a traditional mortgage loan, you’ll need to meet certain criteria to qualify for a bridge loan.
What credit score do you need to qualify?
When you use a bridge loan, you’ll end up with 2 loans. The first is the bridge loan itself, but you’ll also have a mortgage on the new home you’ve purchased.
For residential bridge loans, expect lenders to require a good credit score. Each lender may have different minimum score requirements.
With 2 loans at stake, most lenders favor borrowers with good or excellent credit. If your FICO score is below 680, you might not qualify for a bridge loan.
Bridge loan lenders also require at least 20% equity in your current home. The loan uses this equity, not unlike a home equity loan.
The key difference is in how you use the loan. Of course, the loan term differs as well and the interest rate for a bridge loan is often much higher.
Debt to income ratio (DTI)
Nearly all home loans consider your debt-to-income ratio. Mortgage lenders prefer a debt-to-income ratio of below 36%. Some bridge loan lenders allow a debt-to-income ratio as high as 50%, however.
Check with your lender for their specific requirements when considering your loan options. To calculate your DTI, divide your monthly debt payments by your monthly pre-tax income.
Loan to value ratio (LTV)
The loan-to-value ratio refers to the percentage of the home’s appraised value you can borrow. For bridge loans, you’ll find a range of percentages between 65% up to 85%. In most cases, expect the LTV to be 80% for residential loans.
Benefits of bridge loans
The obvious benefit of bridge loans is that you can buy a new home before selling your old home. Used with care, this strategy provides you with flexibility to buy at the most opportune time.
Without a bridge loan, you may need to make any offers on a new home contingent on the sale of your old home. In a competitive market, this can put you at a disadvantage against other buyers.
In a case where you’re forced to move quickly, like work-related moves, a bridge loan offers a solution. Rather than renting in the new area while waiting for your home to sell, you can buy a new home.
Drawbacks of bridge loans
A bridge loan may not be a perfect solution for all home buyers. Interest rates come in above rates for traditional mortgages. Expect to pay a few extra percentage points for your loan.
You’ll also pay closing costs for the loan, which can range from 1.5% up to 3% for larger loans. When considering the short duration of a bridge loan, these extra costs can make the loan expensive.
For smaller loans, the fees may be even higher as a percentage of the borrowed amount. Usually, you’ll also pay an origination fee.
Risk is another potential drawback. You’ll end up with 2 home loans for a certain amount of time. Some bridge loans allow you to skip payments for a few months.
However, for some households, the risk of taking on loans for 2 homes at once merits some extra thought.
Alternatives to bridge loans
Home equity loan
Bridge loans can be costly, so it makes sense to consider other options. If you have enough equity, you may be able to take a home equity loan instead.
Often, you can qualify for a home equity loan with a lower credit score when compared to bridge loan requirements. Typically, the home equity loan costs less overall.
You’ll also have a longer loan term. Repayment terms range from 5 years up to 30 years. The longer term can help if you’re in a soft real estate market and selling your home may take some time.
Home equity line of credit (HELOC)
Similar to a home equity loan, a home equity line of credit can be a less costly alternative to a bridge loan. With any loan based on home equity, you’ll need to have enough equity in your home to make the strategy viable.
Most lenders want to stay below an 80% loan-to-value ratio on home equity lending. This means most loans based on home equity work better if you have a considerable amount of equity. Consider these options if you have 60% or more in home equity.
With an 80-10-10 loan (or an 80-20 loan), you’re taking a second mortgage on a new home to pay the down payment on the mortgage. With an 80-10-10 loan, you’ll put down just 10% of the home’s purchase price rather than 20%.
This might provide enough room to make the purchase viable. The other 10% for the down payment comes from the second mortgage on the home. The first mortgage pays the remaining 80%.
An 80-20 loan follows the same strategy, but finances the entire 20% down payment with a second mortgage. If home prices fall, it’s easy to find yourself in a negative equity position with 80-20 loans or even 80-10-10 loans.
If you have some money tucked away in your 401k, the IRS allows you to take a loan against your 401k for purchasing a home. Your 401k plan must support this option and the IRS limits the amount you can borrow.
Current IRS limits allow loans of up to $50,000. IRS rules limit your loan to 50% of your 401k balance if you have less than $100,000 in your 401k.
You’ll pay interest on your loan and the loan term is just 5 years. However, you’ll pay the interest back to your 401k account. This helps ensure you don’t fall too far behind on retirement saving.
Use contingency to sell your home
In some housing markets, the safest option may be to use a contingency clause when home shopping. A contingency clause simply says your offer to buy a home is contingent on the sale of your own home.
If you’re buying and selling within the same housing market this strategy can work well. It also reduces your risk — as well as expenses.
You’re still using the equity you’ve built to help buy a new home. You’re just waiting until you sell your existing home before closing on a new one.
What are the costs of a bridge loan?
Fee types and fee amounts for a bridge loan can vary by lender. However, in many cases, you’ll pay several fees — and they can add up quickly.
Expect some or all of the following:
- Loan origination fee
- Home appraisal
- Admin fees
- Title insurance
- Bank wire fees
Add it all up and you could spend $2,500 or more on fees for a bridge loan. Larger loan origination fees can drive total costs higher.
Also, interest rates for bridge loans are usually higher than for other types of home loans. Bridge loans have their place in home buying, but be sure to consider other options as well.
Bridge loans serve a useful function in bridging the financial gap between one home and the next home. If you have enough equity in your current home, a bridge loan can make sense.
Of course, to keep your interest costs down, you’ll also have to be sure your home will sell quickly. As with any financial product, invest some time in understanding the fine print before you sign the bottom line.