What Is A Bridging Loan And How Does It Work?
Whether you’re a real estate investor or a private owner who wants to purchase a second home, you will need to consider the additional expense that a property purchase entails. Purchasing a residential property requires a hefty down payment, as well as various moving costs and lawyers’ fees.
These expenses can seem overwhelming, especially if you’re currently paying the mortgage on your existing home. Fortunately, there’s a type of loan that has been created specifically to help bridge your financial gap in this situation: a bridging loan.
What is a Bridging Loan?
This loan is a lending arrangement created by bridging loan companies to help clients buy another property. The money is used to make the purchase while the owner waits for the sale of their current home or investment. This arrangement may be ideal during instances when you need funds immediately, such as buying from auctions, but are unable to pay upfront.
Bridging loans are similar to a mortgage in a way, because the amount that you may be approved for is largely dependent on your current property’s value. This type of loan can also be considered a secure loan, as your current home typically serves as security for the lender, meaning that they can repossess it if you default on repayments. If you’re considering a bridging loan, you should be aware that interest does apply to these types of arrangements, similar to a mortgage. You have to pay interest during the loan period and repay the principal at the end, and interest rates may be slightly higher for bridging loans. This higher interest rate is applied because the lenders do not make as much profit from interest during a shortened loan term. The primary difference between a bridging loan and a mortgage is the loan duration. The former is a short-term arrangement, which usually has to be repaid within a year, unlike a mortgage which can be stretched out for 20 to 25 years or more.
Types of Bridging Loans
There are two main types of bridging loans:
- Closed loans – You should opt for this type of loan when you’ve determined a sale date for your existing property. This arrangement may increase the likelihood that your loan application will be approved, as your home already has a buyer and this gives the lender additional confidence that you can actually repay the amount you borrowed.
- Open loans – With this type, you may have eyed the new property that you’ll want to buy, but your current home has not been sold yet. Since this is considered riskier than closed bridging loans, you might need to provide proof that you’ve already listed your current home and are waiting for a buyer. The repayment duration for this arrangement typically falls between six to 12 months.
How Do Bridging Loans Work?
The ‘loan to value’ (LTV) figure is crucial when applying for bridging loans, as well as any time you’re refinancing your properties: you need to know the valuation of your home since it helps determine the amount that you can borrow. Nonetheless, your loan application is also assessed using ‘non-property’ factors such as your capability to repay your debt, the market status, and your experience with this type of project (especially if you’re an investor,) among others.
After valuation and approval, you will receive access to the funds and can use them to purchase your second property. You should be aware that there are fees deducted from the loan, such as:
- Initial valuation cost – Even if you’ve already calculated your home’s LTV, the lender may want to get their own valuation done and charge you for it.
- Arrangement or facility fee – Think of this as a payment you make to the institution for facilitating the transaction. It usually costs around 2% of the loan.
- Legal costs – You have to consider the lender’s legal fees as well as your own.
- Exit fee – It’s likened to a prepayment deposit and typically costs 1% of the loan.
- Broker fee – You should be mindful of this expense if you took out the loan using broker services.
Additionally, you should consider the interest payments when calculating how much money you’ll have available. The lender has the power to withhold interest and deduct it from the gross advance right at the beginning of your loan period. Another option is for you to roll up the interest, this means that you reimburse the rate at a lump sum after you’ve repaid the principal loan amount. Lastly, you can also service the interest, which means that you include it in your payment every month, this is the setup that’s most similar to mortgages.
A bridging loan may be a viable option if you’re thinking about purchasing a second property. Although it may be useful to bridge the financial gap while you’re waiting for your current home to be sold, you should be aware of its short duration as well as the fees that it entails.