Bridge Loan

Updated on March 19, 2024
Article byWallstreetmojo Team
Edited byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What is a Bridge Loan?

A bridge loan is a type of short-term credit. It is availed by owners trying to buy a new home to replace their current home. The current property acts as collateral. The loan bridges the interval between the purchase and sale of the property.

The loan comes with two payment options. Borrowers either pay interest each month or opt for a lump sum interest to be paid when the loan is paid off. Due to the risks, interest rates are quite high. The loan has to be paid within a year.

Key Takeaways

  • A bridge loan refers to a short-term source of finance. Individuals and companies can meet urgent cash requirements by obtaining this loan. Usually, borrowers opt for this option when there is a delay in the disbursement of a permanent loan or sale of a property.
  • Lenders secure these loans by demanding collateral—inventory, real estate, and other assets.
  • There are four subtypes—closed, open, first charge, and second charge bridge loans.

Bridge Loans Explained

Bridge Loan

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Bridge Loan (wallstreetmojo.com)

A bridge loan is offered to a company or individual for a short term until the borrower pays back the previously borrowed fund or acquires a permanent source of funds. It is offered by 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.read more. It is usually extended for a period of three to twelve months. It bridges the gap between urgent expenses and cash inflow in the immediate future.

These loans are secured by the hypothecationHypothecationHypothecation 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.read more of movable assets, immovable assets, personal guaranteesPersonal GuaranteesA personal guarantee is an agreement between three parties – lender, borrower, and guarantor, whereby the guarantor has legal binding attached to him to repay the lender and honour the loan agreement if the borrower defaults.read more, and promissory notesPromissory NotesA promissory note is defined as a debt instrument in which the issuer of the note promises to pay a specified amount to a party on a particular date.read more. For individuals, the bank offers a loan against the property that the borrower is buying. However, for companies, inventory or real estate act as collateral.

The amount of loan allowed for each borrower depends on the 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.read more. For example, the maximum loan to value ratio for commercial property is 65%. For residential property, the maximum is set at 80%.

The interest rate on these loans is significantly higher than normal loans. Moreover, they are short-term loans and, therefore, carry additional risk.

–>> If you want to learn Financial Modeling & Valuation professionally , then do check this ​Financial Modeling & Valuation Course Bundle​ (25+ hours of video tutorials with step by step McDonald’s Financial Model). Unlock the art of financial modeling and valuation with a comprehensive course covering McDonald’s forecast methodologies, advanced valuation techniques, and financial statements.

Requirements

Borrowers are eligible for the loan if they meet the following criteria:

Types

The different subtypes are as follows:

#1 – Closed Bridge Loan: The finance period is fixed and is mutually agreed upon by both parties. Lenders prefer closed loans over open loans and hence offer lower interest rates.

#2 – Open Bridge Loan: The date of repayment is not fixed in such a loan. When borrowers are uncertain of when they will secure finance, they prefer open loans. Since the repayment date is not confirmed, lenders charge higher interests.

#3 – First Charge Bridge Loan: The loan provider has a primary right to the collateral when borrowers obtain a first charge loan. If the borrower defaults, then the loan provider has the first right to sell the property for loan recovery. Due to the minimal underwriting risk, interest rates are kept low.

#4 – Second Charge Bridge Loan: In this loan type, the lender has a second charge on the property. Due to high levels of uncertainty, interests are high.

Examples

Let us look at some examples, to understand the practical application of the concept.

Example #1

Let us assume Laura plans to buy a new house replacing the one she currently owns. Laura, therefore, needs to sell the old house—a time-intensive process. The new house will cost her $600,000. Her current house is valued at $800,000.

In such a scenario, Laura can obtain a 12-month bridge loan of $600,000 (which is less than 80% of the current house’s value). With this money, Laura can buy a new house. Within twelve months, she can sell the old house to settle the bridge loan (both the principal and interest amount).

Example #2

ABC Ltd. is a vehicle manufacturer, and the company plans to build a factory worth $15000,000. Therefore, the company can 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.read more to finance this requirement.

But the issuing of corporate bonds may take up to six months. The company feels that they may not get the best deal for the land or the location if it gets delayed—the management wants to start the construction immediately.

In such a scenario, the company opts for a bridging loan. The company obtains $15000,000 credit for six months and will repay the amount when the bonds are issued.

Bridge Loan vs. HELOC

Bridging loans and Home Equity Line of Credit (HELOC) are sources of short-term finance—they facilitate the purchase of the private and commercial real estate. However, they have different purposes and limitations.

The former is a short-term availability of funds until the permanent loanLoanA loan is a vehicle for credit in which a lender will give a sum of money to a borrower or borrowing entity in exchange for future repayment.read more is disbursed. The latter is credited as a lump sum—the borrower withdraws it partially depending on the need. Bridging loan collaterals are usually assets like real estate or inventory. HELOCs are secured against equity interestEquity InterestEquity Interest is the percentage of ownership rights either individual or a company holds in one company which gives holder voting right in that company. They have residual rights in economic benefits obtained from the business or realization from assets.read more in the respective property.

Bridging loans are comparatively expensive—interest rates are high, and so are the risks. HELOCs are cheaper—they allow itemized deductionItemized DeductionAn itemized deduction is an eligible expenditure incurred by the individual taxpayers on various products or services for claiming these expenditures on FIT (federal income tax) returns solely to reduce their tax implications. These are multiple sorts of tax-deductible expenditures incurred throughout the year.read more in tax payments. Bridge loans need to be repaid within a specific tenure—it has to be closed within a year. But, HELOCs can stay active for a long period, say ten years.

Frequently Asked Questions (FAQs)

Who offers bridge loans?

They are offered by banks and financial institutions. They are offered to individuals and companies for the fulfillment of short-term cash requirements. For example, the borrower could be in a waiting period for permanent loan disbursement.

Are bridge loans a good idea?

It is tailor-made for individuals or companies who don’t want to lose a great deal (real estate purchase) due to cash shortage. The loan fulfills the immediate requirement of funds.

Are bridging loans expensive?

Yes, they are more expensive than traditional loans. For the lenders, these loans come with high risks. Therefore, the interest rates are quite high.

Recommended Articles

This has been a guide to Guide to what is a Bridge Loan and its definition. We explain bridge loan meaning, mortgages, interest rates, real estate, requirements, types, examples, and HELOC comparisons. You can learn more about Corporate Finance from the following articles –

Reader Interactions

Leave a Reply

Your email address will not be published. Required fields are marked *