What is a Bridge Loan?

Robinhood Learn
Democratize finance for all. Our writers’ work has appeared in The Wall Street Journal, Forbes, the Chicago Tribune, Quartz, the San Francisco Chronicle, and more.
Definition:

A bridge loan is a type of short-term loan a borrower might use to help fund a new purchase before they get rid of an existing loan.

🤔 Understanding bridge loans

When someone is preparing to make a large purchase while they still have a significant existing financial obligation, they might use a bridge loan to cover the time in between. Bridge loans are common with homeownership. A homeowner might be preparing to buy a home and planning to use the sale of their current home to pay for it. The problem is they still have their existing mortgage and need the money for the new house before the sale closes on the old house. They might use a bridge loan, which would cover them temporarily for the time between finding a new home and closing the sale on the old home. Bridge loans are also used in business.

Example

Suppose Tim and Sarah are in the market for a larger house for their growing family. They currently own a home on which they still have a mortgage. They know they’ll be getting a good chunk of money from their current house but won’t have it quite in time to buy the new house. Tim and Sarah talk to their bank about a bridge loan, which will give them the money they need to buy their new home. They’ll pay back their bridge loan as soon as the sale closes on the current home and they get their capital from the sale.

Takeaway

A bridge loan is like using your credit card for a large purchase right before payday…

The money isn’t in your checking account just yet, but you know it will be in a few days. So you put the purchase on your credit card, knowing you’ll be able to pay it off. When you take out a bridge loan, you know you’ve got a payday coming soon.

Ready to start investing?
Sign up for Robinhood and get your first stock on us.
Sign up for Robinhood
Certain limitations apply

The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory.

Tell me more…

How does a bridge loan work in real estate?

For most people using bridge loans, they are using them in the context of real estate. Bridge loans help homeowners close the gap between the purchase of their new home and the sale of their current one. These types of loans are available to anyone with at least 20% equity in their home.

Many homeowners use the equity in their current home to fund the downpayment for a new home. But in many cases, homeowners are closing on their new homes before closing the sale on the house they’re selling. That homeowner could use a bridge loan to pay for the down payment, and then pay the loan off when they sell their previous house.

Bridge loans on homes can work differently depending on the loan. In some cases, the bridge loan pays for the down payment on the new home. In other situations, the bridge loan might also pay off your current mortgage.

Let’s say you own a home worth $250,000, and you currently have $150,000 in equity in the house. The bank still owns the other $100,000. You might take out a bridge loan for $150,000. The first $100,000 would go toward paying off the rest of your mortgage, while the other $50,000 would go toward the down payment and closing costs for your new home purchase.

Bridge loans usually last for a term of fewer than 12 months. The assumption is that when you eventually do sell your old home, you would use the profits from that sale to pay off the bridge loan.

The amount that you can borrow with a bridge loan depends on the value of your home. The maximum you can usually borrow is 80% of the combined value of the home you’re selling and the home you’re buying. Ultimately, the amount you can borrow will also depend on your lender and how much they are willing to give you.

Bridge loans aren’t right for everyone and certainly have some downsides, but they can be ideal in certain situations. Here are some examples of when a bridge loan might be the right choice for you:

  • Sellers aren’t willing to accept contingent offers. Often people buying a new home while selling an old one have to make their offers contingent on the sale of their old house. In a competitive housing market, sellers might not be willing to entertain those offers.
  • You have accepted an offer on your old home, but the closing date is after the closing date of your new home. Since you’ve accepted an offer already, chances are the sale will go through. Because you’re confident the deal will close, you feel comfortable taking on the bridge loan temporarily.

How do bridge loans work in a business?

In addition to real estate, bridge loans also have a use in business. A business owner might use a bridge loan with a term of up to one year to help them to invest in their business while waiting for an influx of capital.

Companies can use bridge loans to make purchases for new buildings, property, equipment, or inventory. They also might use the money for their business operating expenses. They know they’ll have capital coming soon, perhaps through the sale of stock shares in their company. But they don’t have that money yet, and they need some working capital to help invest in their business.

To qualify for a bridge loan, businesses will have to prove their creditworthiness. In general, they’ll have to have good credit and a low debt-to-income ratio.

What is the difference between a bridge loan and a traditional loan?

If you’re using a bridge loan to purchase a new home, you’re looking at taking out two different types of loans. First, you’ll take out a bridge loan to bankroll the down payment for your new home. Then you’ll take out the traditional mortgage loan for the new house.

The terms of these different types of loans vary quite a bit. The first significant difference in these loans is the term. Mortgages often come in the form of a 30-year loan. A home is a large purchase, and banks know you’ll probably need many years to pay it off.

A bridge loan is much shorter — usually one year or less. Banks aren’t expecting you to pay this loan off slowly over time. Instead, the loan provides short-term funding until you’re able to sell your old home. At that point, you’ll use the profits from your home sale to pay off the bridge loan.

These two types of loans also vary in the interest rates they offer. At the beginning of 2020, the average rate for a 30-year fixed-rate mortgage was 3.99%. Bridge loans, on the other hand, have interest rates of around 8.5–10.5%. Because you’re paying these loans off quickly, banks aren’t making as much money on them. The higher interest rate allows them to profit off the loan anyways.

What are the pros and cons of bridge loans?

Pros

Bridge loans can be extremely beneficial for homeowners who are ready to find a new home, but who aren’t sure how to finance it until they sell their current home. Bridge loans give those homeowners the freedom to buy their new home before they sell the old one.

Bridge loans can also make a lot of sense for people who are moving due to extenuating circumstances. For example, let’s say you’ve accepted a new job in a different city. You have to move fairly quickly. You know you won’t be able to sell your home in the time it takes you to find a new one in your new city, so you can use a bridge loan instead.

Another benefit of bridge loans is that your lender might allow you to defer payments on them. This deferment might last just a few months or until you sell your house.

Cons

For all the advantages they offer, bridge loans have their downsides as well. First, bridge loans tend to have higher interest rates than traditional mortgage loans. While the average rate for a 30-year fixed-rate mortgage at the start of 2020 was 3.99%, bridge loans are often as high as 8.5–10.5%.

Taking out a bridge loan can also significantly increase your monthly debt payments. After all, you might be going from having just one monthly payment (your mortgage) to three monthly payments (your old mortgage, your new mortgage, and your bridge loan).

The other problem with bridge loans is that they are short-term loans, usually of one year or less. The assumption with bridge loans is that you’ll sell your other home, and use the profits to pay off the bridge loan. But what if something goes awry and you aren’t able to sell your house in that amount of time? You’ve now got a substantial debt that you’ve promised to pay but potentially can’t pay on time.

In addition to the higher interest and the risks that come along with bridge loans, they also have additional expenses. As with other loans, your lender is likely to charge you fees such as an origination fee, closing costs, and other administrative fees.

What are the alternatives to bridge loans?

Bridge loans aren’t right for everyone. In fact, many financial advisors don’t recommend them because of the risk they pose to the borrower. Instead, there are alternatives that you could use instead.

Home equity loan

Rather than bridge loans, many homeowners use home equity loans to help them get from one house to the next. In the case of a home equity loan, you borrow against the equity you own in your home.

Home equity loans usually have longer terms than bridge loans — They can range from five to 20 years. They also often have lower interest rates than bridge loans.

Keep in mind that home equity loans aren’t without their risks as well. Just like with a bridge loan, you’re putting yourself into a situation to have three monthly payments, one for your home equity loan and one for each of your two mortgages. You also must pay back home equity loans when you sell your home. So even though they technically have longer terms than bridge loans, you still have to pay them back quickly, if you do sell your home.

Other than the lower interest rates, the significant advantage that home equity loans have over bridge loans is that if you aren’t able to sell your old home as quickly as you thought you would, you have much longer on the loan. So it’s not quite as detrimental if you don’t immediately sell your old house.

80-10-10 loans

Another alternative to bridge loans is an 80-10-10 loan. This type of loan works well for someone who does have some cash on hand for a down payment on a second house, but not quite enough for the full 20% banks typically want. This type of loan allows you to put down less than 20% without paying private mortgage insurance, which banks often require with smaller down payments.

With an 80-10-10 loan, you take out two separate mortgages. The first mortgage is worth 80% of the price of your new home. Then you take a second mortgage worth 10% of your new home’s price. You then make a down payment of 10% of the home’s price. When your old house sells, you immediately pay off the smaller mortgage worth 10% of the new home’s value.

Sell your other home first

While it might not be the most convenient option, it might just make the most sense to wait on buying your new home until you’ve been able to sell your old one. It might cause a few extra delays and headaches, but at least it ensures you won’t be stuck making two mortgage payments indefinitely.

You can still start shopping for your new home if yours hasn’t sold yet. When it comes time to make an offer, you simply make your offer contingent on the sale of your old home.

Ready to start investing?
Sign up for Robinhood and get your first stock on us.Certain limitations apply

The free stock offer is available to new users only, subject to the terms and conditions at rbnhd.co/freestock. Free stock chosen randomly from the program’s inventory.

1317110

Related Articles

What is an Interest Rate?
Updated June 22, 2020

You May Also Like

The 3-minute newsletter with fresh takes on the financial news you need to start your day.
The 3-minute newsletter with fresh takes on the financial news you need to start your day.


© 2020 Robinhood Markets, Inc. Robinhood® is a trademark of Robinhood Markets, Inc.

This information is educational, and is not an offer to sell or a solicitation of an offer to buy any security. This information is not a recommendation to buy, hold, or sell an investment or financial product, or take any action. This information is neither individualized nor a research report, and must not serve as the basis for any investment decision. All investments involve risk, including the possible loss of capital. Past performance does not guarantee future results or returns. Before making decisions with legal, tax, or accounting effects, you should consult appropriate professionals. Information is from sources deemed reliable on the date of publication, but Robinhood does not guarantee its accuracy.

Robinhood Financial LLC provides brokerage services. Robinhood Securities, LLC, provides brokerage clearing services. Robinhood Crypto, LLC provides crypto currency trading. All are subsidiaries of Robinhood Markets, Inc. ('Robinhood').

1200251