When to use a bridge loan?
On the current real estate market, it is quite hard to achieve a situation where it is possible to use the funds gained from the sale of a property immediately with the goal of financing the purchase of new real estate. It is common that the dates just don’t match and the sale of the old property takes more time than predicted. An even more difficult situation occurs when a person wishes to buy a new property before the sale of the old property is completed. In this situation, it is wise to use a bridge loan to cover the gap between the two dates and find a solution. This article will give further details about the uses of a bridge loan.
When describing shortly, a bridge loan is a short-term financial instrument, which helps entrepreneurs „make a bridge“ in order to finance necessary purchases before the sale of property. For a borrower this is a way to lower risks and it gives time to clear up the capital structure or plan the sale of real estate.
Bridge loans have risen in popularity lately and find use on real estate markets all over the world. Real estate developers mostly use a bridge loan to cover short-term capital needs and buy new real estate or develop existing property. It is often used to buy property, renovate it and then sell it quickly for a profit. Old property is used as a security for the bridge loan and the loan size is dependent on the value of the asset. The loan is returned from the funds gained from the sale of the underlying asset during a period previously agreed with the loan originator.
How does a bridge loan work?
In order to demonstrate how a bridge loan works, we bring in a short example.
Let’s say that a developer that wishes to sell existing property, has found a buyer and agreed that the funds from the sale will be transferred on the 10th of November. At the same time, the developer wishes to buy property from the bank, but has agreed to make a down payment on the 30th of October, which is 11 days earlier. In that case, the borrower turns to a credit provider that gives out bridge loans. The credit provider then takes the developers existing property as mortgage for the loan and finances the purchase of the new property.
There is a saying about bridge loans that the bridge should be long enough to reach the other side of the river. This means that if the borrower thinks he can sell his property in 3 months, the bridge loan should cover capital needs for at least 6 months. Usually, the interest rates for a bridge loan are higher than what banks offer because a bridge loan is a high risk loan for the credit provider. It is common for bridge loans to have 8% and up interest rates, with additional fees to the borrower.
A bridge loan can be 3-24 months, although a 12-month period in order to flip a property is the most common. The maximum loan-to-value is 75%.
Currently, the use of bridge loans has increased on the global real estate market and mostly thanks to strict lending rules in commercial banks, which leave developers to search for alternative financing options. Crowdfunding helps developers get the necessary capital for their business and at the same time allows investor to invest in high-reward projects. Bridge loans help boost the economy and enable starting real estate developers to reach their goals. In the near future, the trend will surely continue and the number of alternative financing options on the market increases every day.