Bridging Loans Explained: Everything You Need to Know
Bridging Loans Explained: Everything You Need to Know
You may have heard of a bridge loan before, but do you really know how they work? Here's bridging loans explained in a way that's easy to understand.
Bridging loans are a powerful financial tool. And when buying a new home, they're essential. It's not for nothing that their popularity is on the rise.
If you have no idea what a bridging loan is, that's ok. This article will tell you everything you need to know.
So read on to see bridging loans explained.
Bridging Loans Explained
Bridging loans are short-term loans that help you buy an expensive asset when you don't yet have enough money to do so. They are most commonly used in the context of property purchases, and that's the context we'll be discussing in this article.
Let's say you want to buy a new house, but you haven't sold the house you currently live in.
You might take out a bridging loan in order to pay the down payment on the new house, knowing that you'll be able to pay the loan off once you sell your current house. The loan serves as a bridge to help you get from one home to the other.
Unlike mortgages, bridging loans provide funds quickly, often in a matter of days.
Because they're short-term loans, bridging loans usually have relatively high interest rates and fees. But they are incredibly useful financial instruments and are often worth taking out.
That's the basic idea of bridging loans explained. So when should you take one out?
When to Take out a Bridging Loan
Bridging Loans for Home Buyers
As mentioned above, bridging loans are extremely useful for home buyers.
When you find your dream house, you want to buy it immediately. Otherwise, someone else might buy it while you're trying to sell your current house.
Furthermore, some home sellers might offer you a discount if you're willing to buy the house right away.
For both of those reasons, having access to quick funds is essential, and that's exactly what bridging loans provide. With a bridging loan, you can take your time selling your current house, and once you do, you can easily pay the loan off.
Bridging Loans for Professionals
Bridging loans are also useful for house-flippers and real estate developers.
If you're a house-flipper (someone who buys houses, fixes them up, and then sells them at a higher price), bridging loans can make your life much easier.
You simply take out a bridging loan to pay for the house, fix the house up, then sell the house and pay the loan off, keeping anything extra for yourself.
If you're buying an especially run-down property, you may not be able to take out a mortgage on it. Take out a bridging loan until the property is renovated enough to take out a mortgage.
Bridging loans are also essential for developers who buy houses at auction.
Oftentimes, after winning a house auction, you need to pay the down payment within a matter of days or you lose the house. That isn't nearly enough time to process a mortgage, but it's plenty of time to process a bridging loan.
Those are some of the most common reasons to take out bridging loans explained. Now let's talk about interest rates.
What Determines a Bridging Loan Interest Rate?
As with any loan, one of the most important things to pay attention to when taking out a bridging loan is the interest rate. Bridging loans often have high interest rates, usually between 10% and 20% annual interest, but the rate varies depending on a number of different factors.
The bridging loan is usually taken out against some asset (usually your house), and the value of this asset can have a big effect on your interest rate. Let's look at a few different ways this is done.
In a first-charge loan, the bridging loan is taken out against the value of your new house (as opposed to your current house). If you fail to pay off your loan, the lender has the right to seize your new house. That would obviously put you in a terrible situation, but if the new house is fairly valuable, a first-charge loan might come with a relatively low interest rate.
In a second-charge loan, the bridging loan is taken out against your current house. It's called a second-charge loan because your mortgage lender already has a charge on your current house, so the bridging loan lender would only receive anything left over after the mortgage lender seized its share.
This is a worse situation for the lender and thus comes with a higher interest rate.
Taking Out a Loan Against Both Houses
This is obviously the riskiest option, but it will help you secure a lower interest rate. We probably don't need to say this, but don't go this route unless you're absolutely positive that you can pay off your loan.
Closed-Bridge Loan vs Open-Bridge Loan
Another important factor in determining your loan interest rate is whether it's a closed-bridge or open-bridge.
In a closed-bridge loan, you have an effectively guaranteed source of money in the future that you'll use to pay off your loan (this is what's known as an exit plan). For example, if you've sold your house but the paperwork hasn't cleared yet, you have an effectively guaranteed exit strategy and, thus, a closed-bridge loan.
Unsurprisingly, a closed-bridge loan usually comes with a lower interest rate.
In an open-bridge loan, you have no guaranteed exit plan. You're trying to sell your house, but you can't be sure you'll succeed.
An open-bridge loan not only comes with a higher interest rate, but you'll probably end up accumulating interest for a longer period of time as you wait to sell.
Loan-to-Value Ratio and Gross Development Value
Loan-to-Value (LTV) is the ratio of the size of your loan to the value of the asset you're using the loan to buy. Just as with a mortgage, the lower the LTV the lower the interest rate.
When taking out a bridging loan as a house-flipper, you can often use the gross development value (GDV). This is the expected value of the house after you've made improvements.
Having a GDV higher than the value of the loan is another way to obtain a lower interest rate.
As you can see, there are a lot of different factors determining the interest rate of a bridging loan, but one thing that will never be part of your loan evaluation is your income. Unlike other loans, bridging loans are all about your assets.
Those are the basics of bridging loans explained, but if you have more questions, check out our FAQ section or contact us.
If you think you're ready for a bridging loan, you can apply today and get started!