What is a Bridge Loan?
A bridge loan is type of short term financing option for owners trying to buy a new home to replace their current home which is secured by current property to pay off their mortgage and usually it comes with two payment options, either to pay interest only each month or a lump sum interest when the loan is paid off; hence helping the person to cover the interval between two transactions of purchase and sale.
Features of Bridge Loan
- It is a short term duration loan and the duration can vary from 3 months to 12 months.
- The main objective is to provide quick cash until you can arrange more permanent financing.
- These loans charge much higher interest rates as compare to normal loans because they are short term in nature and they carry extra risk.
- The bridge loan is secured by Collateral Security since in the case of individuals it is given generally for the property that we are buying and in case of companies, it’s given for inventory or real-estate which be acts as collateral.
- The loan to value ratio will decide how much loan you get.
- The loan to value ratio is less as compared to other loans.
- On commercial property maximum loan to value ratioLoan To Value RatioThe loan to value ratio is the value of loan to the total value of a particular asset. Banks or lenders commonly use it to determine the amount of loan already given on a specific asset or the maintained margin before issuing money to safeguard from flexibility in value. is 65% in the case of residential property maximum, it is 80%.
How Does a Bridge Loan Work for Individuals?
This type of bridge loan is more popular in the case of Real Estate
Suppose you were planning to take a long term loan for buying a property and this long term loan is going to take three months time for processing and you have a requirement of immediate cash and you cannot wait for three months in that case, you can take this loan and satisfy your cash requirements and once you get your long term loan after particular time then you can paion”y your bridge loan and you have to bear the interest for the three months of a bridge loan.
Suppose you are planning to sell your current house where you are currently staying and you have already seen a property and you feel you want to buy that house and this is the best deal you can get on that house but you have not yet sold your current house and the Purchased Cost is 60, 00,000 $ for this current house which is 100% yours not any loan or mortgage on this house. And for the house, you want to buy you need 50, 00,000 $. In that case, you can take a bridge loan of maximum $40,00,000 (80% of 50,00,000$ since 80% is the loan to value ratio) and after six months your old house is going to sell at that time (i.e. after six months) you have to pay your bridge loan and you will have to pay interest for that bridge loan.
From the above examples, we saw how the bridge loan works in real estate.
How Does a Bridge Loan Work for a Corporate?
Let us understand this with the help of an example. ABC Limited is a company that plans to build a factory that is for 15,000,000 $. The company wants to issue corporate bondsCorporate BondsCorporate Bonds are fixed-income securities issued by companies that promise periodic fixed payments. These fixed payments are broken down into two parts: the coupon and the notional or face value. for financing this requirement. For issuing corporate bonds it may take up to six months, the company feels that they may not get the best deal for the land or the location which they are getting right now so they want to immediately start the construction in that case they can take such loan. And after 6 months, when a company gets money from bonds then they have to repay the bridge loan.
Types of Bridge Loans
- #1 – Closed Bridge Loan – In this type of loan, the time period of finance is fixed. In this loan, more certainty of repayment found because the time period is fixed by Lender and Borrower.
- #2 – Open Bridge Loan – In this type of loan repayment, the date is not fixed. More uncertainty is involved in this type of loan.
- #3 – First Charge Bridge Loan – In this type of loan, the loan provider has a first charge on the property if the loan taker defaults in repayment then the loan giver has a fist right to sell the property then other lenders.
- #4 – Second Charge Bridge Loan – In this loan type loan giver has a second charge on the property, not the first charge. This loan has a high risk involved.
- Fast cash availability, you can get cash before your property is sold.
- It is a short term loanShort Term LoanShort term loans are the loans with a repayment period of 12 months or less, generally offered by firms, individuals or entrepreneurs for immediate liquidity requirements. These are usually provided at a higher interest rate, these short term loans often have a weekly repayment schedule. as compared to taking mortgage loan from the bank
- Mostly quicker to obtain.
- Flexibility since it plugs the gap only when it’s needed.
- In Initial months no monthly payment is required. You are having time to sell your home and till your home gets sold no need to repay any amount.
- It can improve your financial rating if you repay it on time.
- Easy mode of getting money for auction purchase.
- Expensive for small business tends to be more expensive.
- High-interest rates since generally the interest rate for such loans are more than other types of loans because more risk is involved in this loan.
- Inherent riskInherent RiskInherent Risk is the probability of a defect in the financial statement due to error, omission or misstatement identified during a financial audit. Such a risk arises because of certain factors which are beyond the internal control of the organization. since if the payment on time is not made then late fees or penalty can be charged.
- Unexpected events can spoil your plan-in future, it may happen that after taking a bridge loan you may not be able to sell your property at a price which you were expecting, in that case, you may sell your home at a lesser price to satisfy your obligation.
- A high credit score is needed to get this loan.
- If you are not able to pay a loan on time, then it may adversely affects your credit rating.
- Bridge loan bridges the gap between the time period of financing since you need cash immediately, you can get this requirement satisfying with the concept of a bridge loan.
- Bridge loan refers to the loan taken by the company or individual normally from commercial banksCommercial BanksA commercial bank refers to a financial institution that provides various financial solutions to the individual customers or small business clients. It facilitates bank deposits, locker service, loans, checking accounts, and different financial products like savings accounts, bank overdrafts, and certificates of deposits. for a short term period till pending disbursement of loans sanctioned by financial institutions.
- These loans are repaid out of term loans as and when disbursed by the concerned institutions. Such loans are normally secured by hypothecatingHypothecatingHypothecation is a process where a lender receives an asset offered to him/her as collateral security. It is done mainly in assets that are movable in nature to establish the charge against collateral security for a particular loan. movable or immovable assets, personal guarantees, and demand promissory notesPromissory NotesA promissory note is a negotiable instrument that represents the debtor's or the writer's (the maker's) written consent to pay a promised sum to the creditor (the payee) on a specified date..
- The rate of interest on bridge loans is higher as compared to the term loan.
This has been a guide to what is Bridge Loan and its definition. Here we discuss how a bridge loan works for individuals and corporates along with practical examples. You can learn more about Corporate Finance from the following articles –