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How does a bridge loan work, and how can it help investors finance their property purchases?
After months of scouring the real estate market and doing your research, you’ve finally found it — the perfect investment property at the perfect price.
Now, the only thing to do is to snap it up before someone else does. But you face a dilemma: you have not sold your existing property, the sales proceeds of which you plan to use to buy your new property. Additionally, you have an ongoing mortgage on your current property!
So what are your options? In this situation, investors and home buyers can consider taking on a bridging loan.
A bridging loan does what its name implies. It serves as a bridge between the sale of one property and the purchasing of another. These types of loans are designed to cover the purchase price of a second property and give the borrower the time to sell their existing property.
With a bridging loan, investors can avoid the stress of aligning settlement dates, moving quickly to buy a new home or investment property and get more time to sell the property they own.
However, there are many aspects to this type of loan that need to be looked into before signing on the dotted line, such as interest costs and conditions.
In this article, we answer your most common questions on how this loan works, what costs are associated with this financing option, and how you can use it to your advantage.
What is a bridging loan?
Basically, a bridging loan is a financing option that allows you to buy a new property without having to sell your existing property first. It functions as a financial “bridge” that home owners use to cross the gap between buying and selling.
Also called bridge financing, these home loans are typically short-term loans that have potentially high-interest rates and are usually secured by some form of collateral, such as real estate.
Borrowers can use the equity in their current property for the down payment on the purchase of a new one. This happens while they wait for their current home to sell.
This gives the borrower some extra time and, therefore, some peace of mind while they wait for the sale to be finalised.
When the existing property is sold, the original mortgage is usually discharged, and the bridging loan is then often converted into the chosen home loan for the new property.
Bridging finance can be offered against almost any property or land and can be used for a number of different reasons. This type of financing is popular with landlords, property developers and people who are moving houses.
With this, it’s important to remember that bridging finance may not be available or suitable for every borrower.
If your current property has an existing mortgage, you will end up having to make two payments: one for the bridge loans and for the original property’s mortgage until the existing home is sold. If your financial situation will not allow you to do this, it’s better to find another alternative.
Lenders often require that you have a certain amount of equity in your existing home so you can provide a substantial deposit on your new home to give you a lower loan-to-value ratio (LVR).
Alternatively, some lenders may require that borrowers without equity in their existing property pay a higher interest rate on their new property’s bridging loan.
How does a bridging loan work?
The process starts with a lender working out the size of the bridging loan by adding the value of the property you plan to purchase to your current mortgage then subtracting the likely sale price of your existing property.
This leaves you with your “ongoing balance” or “end debt”, which is the principal of your bridging loan. Afterwards, the lender will evaluate your ability to make mortgage repayments on this end debt.
Both properties will be used as security or collateral, and you will end up with one loan (peak debt) to cover both the existing debt and the new loan.
Between when your bridging loan is advanced until you sell your existing home or the “bridging period or term”, most lenders capitalise interest-only repayments on the peak debt.
This means that you will only need to make payments on the principal and interest (P&I) on your current mortgage, rather than trying to manage repayments on two home loans.
After the sale of your existing property, you can make normal mortgage repayments, plus the compounded bridge loan interest, on the new loan.
How are bridging loans structured?
The way bridging loans are structured can differ from lender to lender and depending on your financial situation.
Under some lenders, borrowers will only be required to make repayments on the original loan until the settlement of the new property. But during the bridging period, the interest on the bridging loan is rolled over to the ongoing balance of your bridging loan.
When your current property is sold and the original mortgage is discharged, you then start making repayments on the principal of that bridging loan, plus the added interest.
Meanwhile, other loan structures may require you to make payments on both loans from the time you open the new loan.
How much can I borrow?
Most lenders who offer bridging finance will go up to 90 per cent of the property value. However, they’re harder to qualify for, and LMI (Lenders Mortgage Insurance) will be payable.
A bridging loan can also allow you to borrow up to 100 per cent of the purchase price of your new property, plus the associated costs. This is particularly useful if you are purchasing a property that is outside of your current borrowing capacity but will become affordable once you’ve sold your existing property.
What are the types of bridging loans in Australia?
There are two main types of bridging loans offered by lenders in Australia: closed bridging loans and open bridging loans.
Closed bridging loans
This is a loan where you agree on a date that your existing property will be sold, after which you can pay out the remaining principal of the bridging loan.
This is suitable for borrowers who have already exchanged on the sale terms of their existing property and know what date their contract for sale will settle. Because sales rarely fall through after the exchange, lenders tend to see them as less risky.
Open bridging loans
This is a loan that does not have an agreed settlement date but instead a general loan term (typically six or 12 months).
This type of loan is suitable for borrowers who have found their perfect property but have not yet found a buyer for their existing home. Typically, the lender will ask for extra details when taking out this loan, such as proof that the original property is on the market.
Requirements and conditions for a bridging loan
Depending on the lender and specific product you choose, some of the criteria and considerations that could apply to bridging loans include:
How much does a bridging loan cost?
Pros and cons of bridging loans
Like any financial option, it’s important to look at the pros and cons of bridging loans.
Pros of bridging loans
Cons of bridging loans
Remember to read the key facts sheet and other loan documentation, as well as the lender’s terms and conditions, before making a decision to take out a bridging loan.
Disclaimer: The information provided in the article is general and should not be perceived as personal advice. It is highly recommended to consult with financial advice from a suitably qualified adviser.
Bridging finance or a bridge loan allows homeowners to buy a new property without selling or while waiting for their existing property to be sold.