Pros and Cons of Bridge Loans
The Advantages & Disadvantages
Real estate bridge loans are short-term loans against equity within a borrower’s existing real estate that allows for purchasing new real estate. Once the new real estate is purchased, the previous property is sold to pay off the bridge loan.
Residential bridge loans can be the perfect financing tool for homeowners and real estate investors in specific situations. It is important to understand all the pros and cons of bridge loans prior to obtaining this type of financing.
Pros of Bridge Loans
PRO – Access equity within a property without selling
The main advantage of a bridge loan is quickly accessing the equity within an existing property without initially selling it. The funds raised by the bridge loan are then used to acquire the new property. Once the new property is secured, the previous property is sold to pay off the bridge loan.
Bridge loans against investment property can be funded very quickly. Within 3-5 days if necessary. Residential bridge loans against a primary residence will take 2-3 weeks due to the current federal regulations that all lenders must comply with. Hard money bridge lenders can provide approval and funding at a much faster rate than banks who offer bridge loans.
PRO – Avoid the expense and inconvenience of moving twice
A homeowner with significant equity in their home but not enough cash for a down payment or all-cash could choose to do the following:
Move to temporary housing and sell the current home. Once the home is sold, use the sales proceeds to purchase the new home. When the sale of the new home is complete the homeowner can then move from temporary housing to the new home.
If the homeowner decided to obtain a residential bridge loan, the process would allow for only having to move once. The bridge loan would provide the needed funds to purchase the new home. Once the new home is purchased the homeowner moves into the new home and sells the previous home.
PRO – Exempt from the “Ability to Repay Rule” (income requirement)
Current federal regulations for owner-occupied loans require the borrower to prove their income with 3rd party documentation and the lender must ensure the borrower’s debt to income ratio remains below a certain level.
Borrowers who are unable to provide sufficient income documentation will not be able to obtain an owner-occupied loan due to the Ability to Repay Rule. This rule applies for both conventional lenders such as banks and credit unions as well as private hard money lenders.
Residential bridge loans are a special exception as they do not have to meet the Ability to Repay Rule since the sale of the existing property once the new property is sold will repay the loan. Bridge loans are especially beneficial for seniors, retirees, self-employed individuals and those currently without significant income but have plenty of equity within their primary residence.
PRO – Present a purchase offer without the contingency to sell existing home
Buyers sometimes submit a purchase offer contingent upon their current home selling prior to closing the new purchase. Buyers are forced to do this when they do not currently have the liquidity to purchase the new home and need the sales proceeds to complete the purchase. In some situations this type of offer can work, but it provides a great deal of uncertainty for the seller and does not allow for a quick, clean sale. Any other comparable offer without this type of contingency would be accepted instead.
In a hot real estate market, a purchase offer with a contingency for the buyer to sell their existing home is unlikely to be accepted or even acknowledged. If the buyer instead decided to first obtain a bridge loan against their home they would be in much stronger position. A large down payment or all-cash offer has a much larger likelihood of being accepted by a seller.
A residential bridge loan can transform a potential purchase offer from one of the weakest possible offers (contingent on sale of existing home) to the strongest type of offer (all-cash).
PRO – Receive loan approval when denied by banks
Hard money bridge loan lenders are asset-based and primarily focus on the real estate value and the borrower’s equity in the real estate. As long as the borrower has sufficient equity in the property, hard money bridge loan lenders can overlook poor credit scores and issues on a borrower’s record such as short sales, foreclosures, discharged bankruptcies and loan modifications.
Banks are much more focused on a borrower’s creditworthiness and income history. Any recent issues on a borrower’s record will be a red flag for the bank and likely cause the bank to deny the borrower’s bridge loan request.
PRO – Obtain a bridge loan against property currently listed for sale
Conventional lenders typically will not provide loans against real estate currently listed. If a property is on the market this is generally a good indication a loan against this property will be very short-term. Banks do not want to complete approval, underwriting and funding and then have the loan be paid off after a couple months.
Hard money bridge loan lenders focus on short-term loans and are happy to provide bridge loan financing against real estate that is currently on the market.
Cons of Bridge Loans
CON – Interest rates higher than conventional loans
Bridge loan rates from hard money bridge loan lenders are higher than conventional lenders. The speed of approval and funding from a hard money bridge loan lender will typically warrant the higher expense.
While the interest rate is higher compared with conventional loans, the borrower understands that bridge loans are short-term (12 months or less) and only few monthly payments may be required. Because of the short-term nature, the overall interest paid on the bridge loan will not be significant.
CON – Higher transaction costs
It is common for the origination fee for a hard money bridge loan to be between 1.5-3 points depending on the lender. The borrower will also be responsible for the standard real estate transaction fees that are required for any loan such as escrow, title, notary and recording fees.