It’s a situation in which many US homeowners will eventually find themselves. It’s time to buy a new home, whether because of a relocation, a new job, downsizing their living quarters, or for some other reason. However, they also need to sell their current home. Buying a second home without selling the first one seems counterintuitive, particularly for everyday working Americans without ultra-deep pockets.
There is good news – a bridge loan can help. Not only that, but these financial tools can also be cost-effective. In this guide, we’ll explore the topic and outline what borrowers (and their realtors) need to know.
Between a Rock and a Hard Place: The Situation for Many Homeowners
Pre-coronavirus, the housing market tightened up over the course of several years. Inventories of homes for sale were at all-time lows, and more buyers were clamoring for their piece of the American Dream than ever before. In the midst of shelter-in-place, real estate prices are expected to come down (maybe), but low inventories in most markets will continue to apply upward price pressure. Post-virus, the changing landscape of the economy and job markets may result in more families moving. With continued low inventory and increasing demand, it might seem like the perfect time to sell a home, but that leaves the family in a quandary.
Should they pray that their home sells at the same time that their new home closes? Most would be well-advised not to hold their breath on that.
Do they attempt to sell their home and then buy a new one? If so, where do they live between the closings? Renting a hotel or motel room is incredibly costly. Plus, there’s the cost of storage for their possessions to factor into the equation.
Do they put their home on the market and move into a rental during the interim while they look for a new home to buy and for their old home to close? Again, that’s costly and time-consuming.
Do they enter into an agreement to buy a new home, but make the offer contingent on the successful sale of their current home? Many sellers flat out refuse such an arrangement, particularly if the homeowners have yet to start the sales process, which can extend many months.
Homeowners in areas with limited home inventories are caught between the proverbial rock and a hard place. In some cases, it leads them to make rash decisions and acting in ways that go against their best interests. They may do some overbidding on homes or settle for a property that’s not really what they want, intending only to stay for a few years before starting the process once more.
There is another option here, though. A bridge loan can allow homeowners to buy a second home while still waiting for the first one to sell. While that might seem like it goes against conventional financial wisdom, there’s a lot to gain here.
Crossing the Divide: What Is a Bridge Loan?
A bridge loan is precisely what it sounds like – a financial tool designed to help homeowners bridge the gap between the sale of their existing home and the purchase of their next one. To quote US News and World Report, “A bridge loan is a short-term loan used in both commercial and residential real estate. Homebuyers sometimes take out bridge loans, which give them the money to help them buy a home before they sell their current house that can make the process go more smoothly. You move right into your new home – and then you’re out and can focus on selling the old one.”
Why Might Someone Need a Bridge Loan?
First, let’s take a quick look at why a homeowner might need a bridge loan when purchasing a new property. You’ll find more than one factor limiting financial ability here, including the following:
- The equity from the old home needs to freed up so that it can be used as a down payment for the new one.
- Cash from selling the hold home needs to be used for closing costs on the new one.
- They most likely cannot qualify for two bank mortgages, thanks to Dodd-Frank’s stricter lending guidelines.
- They find themselves in any of the situations we discussed above and increasingly think about acting outside their best interests and landing themselves in a difficult situation.
Challenges with Bridge Loans
As you can see, bridge loans have a great deal to offer. However, the situation isn’t always so simple. If there weren’t, then many more home buyers would go this route. So, what’s the catch? Simple – bridge loans are expensive, and they require more equity in the current home than some sellers might have. And, as touched on in a previous section, it comes down to getting another mortgage. Some borrowers just won’t have the financial ability to pay for two such loans.
With that said, bridge loans can be incredibly helpful for many homeowners. And, although interest rates on a bridge loan are higher than a traditional bank loan, the financial benefits often offset the higher rates and fees.
The Bridge Loan Process: How It All Works
Before we explore how a bridge loan can be not only cost effective and oftentimes pay for itself in the long run, we need to explore how they work. While bridge loans are similar to other financial tools, they differ in some key areas. In a perfect scenario (we know, it’s never going to happen, but bear with us!) this is how the process works:
- You decide to sell your home and buy a new one.
- You find a lender offering a bridge loan.
- The loan gives you access to the equity in your home.
- You use that equity to qualify for a loan for up to 100% of the purchase price of your new home.
- You move right into your new home.
- Your old home sells, and you use the proceeds to pay down on the bridge loan.
- Now you refinance the remaining balance of the bridge loan with a new, low rate bank loan.
Sounds great, right? It can be incredibly helpful for homeowners caught in a difficult situation. However, it’s important to know a few things about the inner-workings of bridge loans and how they differ from other financial options out there.
- In most cases, a bridge loan only offers up to about 80% of the combined LTV (loan-to-value ratio) of your existing home and your new home. This means you have to have enough equity in your old home or additional cash if there isn’t enough equity. Note that some lenders have differing LTV ratios, such as a maximum of 70% LTV. You’ll need to research your lending option to find one that has an LTV maximum that fits your situation. However, remember that most lenders will not go over 80% LTV.
- If you qualify, but only barely, you may not get enough from the bridge loan to cover all the costs you’ll need buy your new home. However, sellers with, say, 25% or more equity in the existing home are usually in good standing here.
- Bridge loans are short-term affairs, meaning that you’ll be required to pay the entire loan off within a year or less. Because of this, you need to watch the interest rate. The interest assessed will always be higher than on a conventional home loan just because of the nature of bridge loans, but you can (and should!) still shop around to get the right rate.
- In most instances, the interest rate on a bridge loan will be double the interest on a comparable prime rate mortgage. However, keep in mind that you will only pay interest on the money for as long as you keep the loan. And since most bridge loans have no prepayment penalty, if you pay it off in a few months, your cost of funds will be quite a bit less than the annual rate.
- All bridge loans come with fees attached, but you should compare lenders to make sure that you’re paying as little as possible. Besides the higher interest rate, borrowers should expect to pay origination fees (based on the size of the loan) as well as documentation, underwriting and administrative fees.
When Does a Bridge Loan Make the Most Sense?
As we’ve outlined, a bridge loan can allow you a great degree of freedom and flexibility. It can remove a lot of the stress from the process of buying a home while selling your current property. Here are situations where a bridge loan can make the most sense.
- A Competitive Market: One situation in which a bridge loan makes the most sense is in a competitive market. Here, being able to purchase a new home more quickly and without “contingencies” will help you get the house you want, allowing you to compete with cash buyers. A bridge loan allows your realtor to make offers on your behalf that “mimic” cash offers. Sellers love this and it will give you a strong leg up.
- Necessary Upgrades: Another situation in which a bridge loan makes sense is when you want to buy a new home, but have time to make necessary repairs and upgrades to your existing home. This allows you to take advantage of both natural real estate appreciation in the area, plus the appreciation of important upgrades, such as a new kitchen, a bathroom renovation, landscaping, finishing out the basement, and more. By maximizing the value of the old home, you can get top dollar for the property, which helps to offset the costs of the bridge loan.
- Lump Sum Coming: If you know that you have a significant lump sum coming, whether that’s an inheritance, a settlement, or some other financial windfall, it can make sense to take out a bridge loan. This is particularly true in states like California where real estate is in exceedingly short supply, and property values can climb quickly. In these situations, buying now can help guarantee that you pay significantly less than if you waited.
- Contingent Offers Don’t Work: If you’re located in a seller’s market, you can almost count on sellers refusing a contingent offer. That’s bad news for homeowners who need to move now. Even in a buyer’s market, many sellers are unwilling to accept a contingent offer simply because there’s a lot of ambiguity here. After all, it can take months for a home to sell, and who wants to wait that long for their money when they can simply sell to another buyer and get cash now? A bridge loan can help to enable your move now even if your home hasn’t yet sold.
Pros and Cons of Bridge Loans
Is a bridge loan right for you? It could be. They can be quite cost-effective in the right situations. However, even in those cases, bridge loans come with pros and cons that you will need to weigh for yourself. We’ve listed both below to help you make an informed decision.
- You can make “cash-like” offers and avoid sale contingencies.
- You can make an offer on a home now, rather than waiting until yours sells.
- You can avoid living in temporary housing, whether that’s a rental home, an apartment, or a hotel.
- In many cases, you can pay on interest only, or even have your payments deferred until your home sells.
- You can take advantage of appreciation to increase your equity in both the old home and the newly purchased on during the interim.
- You avoid the stress and cost of having to move twice.
- You have more time to search for the perfect house without the additional pressure of finding a temporary place to live.
- You can make upgrades and repairs to maximize the value of the old home.
- You’ll be paying a higher interest rate and APR than with a conventional loan.
- Bridge loans come with higher fees than conventional mortgages.
- You will be making two mortgage payments, at least for a few months.
- No lender offers a bridge loan on a home with more than 80% LTV, and some lenders mandate even lower rates.
- If your prior home doesn’t sell as quickly as anticipated, you could be paying a lot in interest payments.
Ultimately, bridge loans, while not for everyone, can be viable, cost-effective financial tools for those in the right situation. If you cannot afford a down payment without the equity built up in your current home, or if you are in an area where property appreciation rates mean that buying right now is a better idea than waiting a year, a bridge loan helps save money. With that said, it is still essential to work with the right lender to secure the best possible terms, the lowest interest rate, and other benefits.