Bridge loans are used to provide immediate cash flow to tide over difficult times until a company can secure long-term finance. The borrower will use the loan as working capital. These loans carry a high interest rate and are backed by collateral. Let us look at what bridge loans offer as opposed to traditional loans:
They have a faster approval process compared to traditional loans. This trade-off comes at a huge cost. Bridge loans have high origination fees, are short-term, and have high interest rates. They are used when the company is in dire need of funds before a more permanent long-term solution. For example, a company that is raising a round of equity financing expected to close at the end of 5 months will need working capital during that time. This is where the bridge loan comes in.
Bridge loans in real estate
Bridge loans are used in real estate where buyers use the money while transitioning between houses. Homeowners may prefer bridge loans to traditional loans when they suddenly have to relocate due to work or other reasons. Bridge loans are acquired using your current home as collateral.
Bridge loans come in different shapes and sizes. Some pay off the first mortgage as the bridge loan comes to a close. Others may increase the debt. However, contingency measures must be in place for if the buyer of the old home defaults on his payments and the deal falls through, you will be in a spot of bother. It is therefore advised not to make use of a bridge loan. Instead, one may borrow against a 401K or opt for secure loans using stocks and bonds. You may also consider home equity loans that have repayment periods of 5–20 years.
Many lenders follow a underwriting approach as opposed to conforming to debt-to-income ratios when it comes to bridge loans. Often, lenders hold back on the bridge loan. These lenders make conforming loans, that is, standard Federal Housing loans that add up the loan payment on the current house with the mortgage of the moveup house. This is done because the borrower has an existing mortgage that must be paid off, and the deal for the new house must be secured before the current house is sold, which means that for a short period, the buyer will own two houses.
Let us look at a few of the benefits and drawbacks of bridge loans:
Benefits
- The buyer may put up their property for sale immediately without worrying and buy another
- For a few months, payments need not be made
- If a buyer makes a contingent offer to purchase a house and the seller issues a notice to perform, the buyer may remove the contingency to sell and proceed with the transaction
Drawbacks
