(Updated February 2015)
You've found the perfect house for you and your family, but the house you're living in hasn't sold yet. Where are you going to get the money to make sure that the new house doesn't get away? A bridge loan, although risky, may get you through these troubled waters.
Remember when you were young and on your family vacation, and your parents would drive over a very high, narrow bridge? You were petrified and thrilled at the same time. Bridge loans, although having nothing to do with water, can elicit the same feelings. These instruments give people the opportunity to buy the house of their dreams before they've sold their old one-but the risks can be dizzying.
A bridge loan, sometimes called a swing loan, gets its name because it bridges the gap between your old mortgage and your new one. Just as a regular bridge might carry you safely from one side of a river to another, a bridge loan can transport you smoothly from your current mortgage to your new one with a minimum of fuss and bother.
Building the bridge
There are two types of bridge loans. The first pays off the mortgage on your current home and makes a down payment on the new one. This means that you pay the mortgage only on the new property, agreeing to repay the bridge loan when the old home sells.
The second type of bridge loan is actually a conventional home equity loan or line of credit, in which you use the equity in your current home to borrow the money for the down payment on your new one. That may seem like a more straightforward approach, but the difficult part is that you end up with three mortgage payments (the one on your old home, the new home and the home equity loan) until you sell your former home and pay off two of the loans.
One of the nice things about bridge loans is they eliminate the need for contingency clauses when buying your new home. That's when you sign a contract to purchase a home, but the purchase is contingent upon selling your existing home fairly quickly - usually 30-60 days. That puts a lot of pressure on you to sell your old home and may force you to settle for a lower price than you'd like. With a bridge loan, you don't have to rush to sell the old place, so you're in a better position to get a fair price for it.
The traditional bridge loan
The first type mentioned above is a traditional bridge loan, which provides a short-term influx of cash needed to buy your new home. It pays off the remaining mortgage on your current home and provides enough to put a down payment on the new one. The bridge loan is secured by the equity in your old home and is paid off when that home is sold.
This means, of course, that you have two mortgages: the bridge loan, which paid off your old mortgage and provided the down payment on the new property, and the purchase mortgage on the new home. However, a bridge loan is usually structured so you don't have to make any payments until your old home is sold, at which point the proceeds from the sale are used to pay off the entire thing, including interest.
In other cases a bridge loan may be set up as an interest-only loan, where you have to make interest payments until your old home is sold and the loan paid off. Either way, it allows you to avoid having to make full mortgage payments on two homes until the old one is sold.
Of course, you do have to pay for this convenience, and the interest rates on bridge loans is higher than what you'd pay on a conventional mortgage - often 2 percentage points or more higher. A bridge loan is also a temporary arrangement - they often must be paid off within 4-6 months, so you must sell your old home within that time. That's longer than you'd have with a contingency clause, but doesn't allow you to drag your feet on the deal either.
Before going down this path, talk to a real estate agent to find out how long houses such as yours are taking to sell. If the market is really slow, you need to consider whether you can sell your old home within the time allowed. The risk is that you could start running out of time and have to start lowering your price in hopes of a quick sale.
To be sure, bridge loans of this sort are much more difficult to find these days than they were before the housing crash. However, some lenders are beginning to offer them once more, particularly among smaller, specialty lenders.
The HEOC alternative
A home equity loan or line of credit (HELOC) is another way to bridge the gap between buying a new home and selling your old one. In this arrangement, you simply take out a home equity loan or HELOC on your old home and use the funds to cover the down payment and closing costs on the new.
The primary advantage of this approach is that it's much easier to arrange than a traditional bridge loan. However, for it to work, you absolutely must arrange the loan prior to putting your old home on the market. Most lenders will not allow you to borrow against the equity in your home once it's been listed for sale.
A HELOC works well for this sort of arrangement because they're set up as interest-only loans during their "draw" period, the time during which you can borrow against your line of credit. So you can borrow the money you need for your down payment and closing costs, and only pay interest charges on that amount until your old home is sold and you can pay the whole thing off. With a regular home equity loan, you'd be making principal payments as well.
A HELOC also lets you borrow money exactly when you need it - once the line of credit is set up, you can wait until you actually need the funds to draw against it and start paying interest. A regular home equity loan would need to be set up far enough in advance to ensure you had the cash in hand when needed, and you'd be paying interest on it the whole time as well.
The downside of this approach is that it means you're continuing to make two full mortgage payments, and payments on the home equity loan as well, until you've sold the old home. That can be a financial strain for many. Plus your lender will want to verify that you have sufficient income to make the payments on all three loans indefinitely. At the same time, you eliminate the deadline needed for selling your old home that you'd face with a regular bridge loan or contingency clause.
Going over a bridge is always breathtaking. It's the same with a bridge loan. It could be the very thing you need to secure the house of your dreams, but weigh the risks carefully. Other alternatives, like dipping into your home equity, may save you many frightening moments while getting you to your destination safely and happily.