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What is A Bridge Loan And How Does it Work?

July 17, 2023 • 1254 views

A bridge loan, also known as interim financing or swing loan, is a short-term loan that serves as a temporary solution to bridge a financial gap. It is commonly used in real estate transactions but can also be utilized in other situations where immediate funds are needed. In this article, we will explore the concept of bridge loans, how they work, their characteristics, and their potential benefits and risks. So, keep reading further.

What is a Bridge Loan?

A bridge loan is a kind of short-term loan that is designed to provide borrowers with financing during any transitionary period. As the name suggests, it “bridges” the gap between the immediate need for cash and the availability of a more permanent source of funds. These loans provide quick access to cash to cover current obligations while waiting for access to a higher amount.

Sometimes, individuals and businesses find themselves in need of immediate funds while waiting for loan approval. In such situations, they can apply for a bridge loan to fulfil their commitments during the waiting period. 

Bridge loans are typically offered for a short duration, usually between two weeks and twenty-four months, and they require substantial collateral to support them. Also, it is important to remember that these loans incur a much higher interest rate. Now that we know the basics of a bridge loan, let us see how this type of financing works.

How Does a Bridge Loan Work?

A bridge loan can benefit both businesses and individuals. For instance, a person who wants to buy a new home but is still in the process of selling their current one may make use of this loan. It will allow the borrower to use this fund in their current home as a down payment for the new home. This way, they can proceed with the purchase while waiting for their current home to get sold.

On the other hand, when businesses are in a situation where they need money to cover their expenses while waiting for long-term financing, they often consider bridge loans. Suppose a company is in the process of raising funds through equity financing, and it is expected to be completed in about six months. During this waiting period, the company might choose to avail of a bridge loan. This loan would provide the necessary working capital to cover essential expenses. The bridge loan thus acts as a temporary solution to keep the business running smoothly until the expected funding comes in.

Usually, lenders are selective in sanctioning the loan when it comes to offering real estate bridge loans. They prefer borrowers who have a strong credit history and manageable debt-to-income ratios. However, it is important to note that lenders typically only provide real estate bridge loans up to 80% of the combined value of both properties. This means that borrowers need to have substantial equity in their original property or a good amount of cash savings available. In other words, the borrower must either own a significant portion of their current home or have enough money saved up to meet the lender’s requirements.

Bridge Loan Example

Here is an example of how bridge loan works:

Let us assume, you get a bridge loan from a lender for Rs.70 Lakh from your current home that is worth Rs.1 Crore. From your previous loan, the amount of Rs.50 Lakh balance is left. Rs.50 Lakh from Rs.70 Lakh, will go towards the mortgage, and Rs.2 Lakh will go towards the closing costs of the first loan. After clearing all the liabilities, you will now have Rs.18 Lakh, to be used for any of your next purchases.

Following are examples of a few scenarios in which a bridge loan is applicable:

  • If you are not able to pay for the down payment of a new house without selling the current house.
  • You need to quickly purchase a new home due to a career transition.
  • The starting date for your new home purchase is scheduled after the closing date for the sale of your current home.
  • You prefer to secure a new property before selling your current one.
  • Sellers in your desired area aren’t comfortable with contingent purchase offers.

Different Types of Bridge Loans

There are mainly four types of bridge loans, lenders offer these loans to borrowers depending on their creditworthiness and preferred terms. Here is a detailed list of the different classifications of these loans:   

1. Closed Bridge Loans

 A closed bridge loan is a specific kind of bridge loan that has a predetermined source of repayment or exit strategy. Like other categories of bridge loans, it is short-term in nature. It is less risky than open bridge loans, which means it reduces the uncertainties for the lender. Having a definite repayment date provides more certainty for everyone involved, and that is why lenders offer lower interest rates on this type of loan.

2. Open Bridge Loans

An open bridge loan does not have a specific repayment source or exit strategy. Here, the borrower has the freedom to repay the loan within a wider range of time frames. This loan category is riskier than closed ones. Here, the lender evaluates the borrower’s financial position and creditworthiness more carefully.

3. First Charge Bridge Loan

A first-charge bridge loan is a temporary financing choice that is secured by having the first claim on a property. The term “first charge” means that the bridging loan has the highest priority when it comes to other loans or claims on the property. It means that the bridge loan lender has the first right to the property’s value if the borrower fails to repay the loan. This gives the lender a greater level of security compared to other loans or charges that may come later.

4. Second Charge Bridge Loan

It is a type of short-term loan that you can get when you already have an existing mortgage or a “first charge” on your property. Since they carry a much higher risk of default, lenders do not offer repayment tenure of more than 12 months, which also attracts a higher interest rate.

In second charge bridge loans, the bank will start the repayment tenure, only if you have paid all your previous liabilities accrued from the first-charge bridging loan. Also, it is very important to remember that, the lender of the second charge loan will have similar repossession rights on the collateral as the first lender.

Also Read - Short Term Loan Vs Long Term Loan: Differences, Benefits, Characteristics

Pros and Cons of Bridge Loans

There are various pros and cons of bridge loans. Here are a few examples:

Pros

The advantages are as follows:

  • If you avail a bridge loan, before you sell your current home, you will get the chance to purchase a new house.
  • A bridge loan will allow you to make an offer on a new home without any sale contingency.
  • In cases of a sudden or transition period, it can provide additional funds.
  • Bridge loans can be a very helpful short-term solution in cases of emergency financial needs.
  • Until you do not sell your previous property, there is potential for interest-only payments, or deferred payments.

Cons

The disadvantages include:

  • Bridge loans usually incur higher interest or annual percentage rates than normal loans.
  • Before any lenders approve the loans, they ask homeowners to have at least 20% of home equity built up.
  • In case you are looking to obtain a new bridge loan, there are a few financial institutions that will extend it.
  • It is very difficult to manage two mortgages together.
  • If you are having trouble selling your current property, it will lead to foreclosure.  

Bridge Loan Alternatives

Following are some of the most important alternatives to the bridge loan:

  • Personal Loan: A Personal Loan is considered to be the best alternative to bridge loans. This loan type can be fruitful when you have a good credit score and a lower DTI ratio. It will allow you to get loans with a much better interest rate than any bridge loan mortgage. Keep in mind, in these loans terms and conditions vary from lender to lender.
  • HELOC: This type of loan works like a credit card. It is very similar to a home equity loan, as it draws against your current home equity. The interest is charged on the amount you borrow, not on your allotted fund and generally, these loans have a much more favourable interest yield. However, many lenders will not approve the loan if you plan to sell your current house.
  • 80/10/10 Loans: Otherwise known as a piggyback loan, in this loan borrower, needs to put a 10 per cent down payment to finance two mortgages — the bank will allow the first mortgage for 80 per cent of its price, and the remaining 10 per cent you can use it as a second loan.
  • Home Equity Loan: This type of loan can be a great solution when you have a comprehensive idea about the exact amount of how much you need to borrow for your new home’s down payment. The bank will provide you with a lump-sum amount against the equity of your current home. The repayment terms of these loans are generally longer up to 240 months. Other than that, these loans offer much better interest rates compared to bridge loans.
  • Business Line of Credit: This type of line of credit works similarly to the HELOC loan, and you will be charged interest only against the amount you borrow. Lenders generally allow up to 120 months of loan repayment terms. Generally, business lines of credit are much more challenging and have a significantly higher interest rate than any bridge loan.

When Should You Consider Applying for a Bridge Loan and Why?

A bridge loan can come in handy if you want to buy a new house before selling your current one. You can use the borrowed money to pay off your existing mortgage and use the rest as a down payment for the new home. It can also serve as a second mortgage to cover the down payment.

If you own a business, you can use this short-term financing option to cover operating expenses while you await your long-term financing funds. The borrowed money can also become useful for business expansion, say, in the form of purchasing real estate. Also, this type of loan can be used to make the most of time-limited opportunities to acquire inventory and other essential resources for your business.

How to Get a Bridge Loan in 3 Steps?

When looking for a bridge loan, follow these steps to complete the simple and fast procedure:

  • Step 1: Click on the ‘Apply Now’ button and enter all the necessary information
  • Step 2: Fill in your personal information, such as date of birth, Permanent Account Number card details, and residential and employment details.
  • Step 3: Next, upload the necessary documents and hit the ‘Submit’ button.

Once your application is processed, the lender will notify you within a few hours.  

Conclusion

In conclusion, bridge loans are a temporary financing option used to bridge a financial gap in real estate transactions or other situations requiring immediate funds. While they provide flexibility and speed, borrowers must carefully consider the associated costs and risks.

It is crucial to assess personal financial circumstances and explore alternatives before deciding to pursue a bridge loan. Consulting with a financial advisor or real estate professional can provide valuable guidance in determining the suitability of a bridge loan for individual needs.

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Frequently Asked Questions

  • What is the time period of a bridge loan?

In India, the general time period of a bridge loan is between two weeks to two years. This means that you have a flexible window of time to repay the loan based on your specific needs and circumstances.

  • Is a bridge loan secured or unsecured?

Bridge loans are a type of loan that is backed by collateral. If you have a good credit history and an asset that you can use as collateral, you can easily apply for a bridge loan to meet your short-term financial needs.

  • What is the approximate interest rate charged by banks on bridge loans?

The approximate interest rate charged by banks on bridge loans is generally between 12% and 18%. Other than that, banks also charge a processing fee, which ranges between 0.35% to 2%.

  • Can we extend bridge loans?

These loans are usually short-term loans that have a repayment tenure of a maximum of six months to twelve months. Lenders usually do not extend the loan, since these are very high risk.

  • What is the most important difference between long-term and bridge loans?

Since these loans are short-term loans and are usually used for buying new property, they usually have a higher interest rate than long-term loans. 

Disclaimer

We take utmost care to provide information based on internal data and reliable sources. However, this article and associated web pages provide generic information for reference purposes only. Readers must make an informed decision by reviewing the products offered and the terms and conditions. Personal Loan disbursal is at the sole discretion of Poonawalla Fincorp.
*Terms and Conditions apply

poonawalla fincorp team

Poonawalla Fincorp Team

Our team of expert writers and editors are passionate about providing authentic and valuable information on finance. Our aim is to simplify financial and finance-related concepts. We strive to help our readers become more aware and empowered to make informed financial decisions.

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