- A bridge loan is a short-term form of financing that is used to meet current obligations before securing permanent financing.
- It provides immediate cash flow when funding is needed but is not yet available.
- A bridge loan comes with relatively high interest rates and must be backed by some form of collateral such as business inventory or real estate property.
- The loan can be accessed by either individuals and companies to meet certain obligations.
- Bridge loans are usually arranged within a short time and with little documentation.
For example, if there is a lag between the purchase of a real estate property and the disposal of another property, the buyer may take a bridge loan to facilitate the purchase. In this case, the original property becomes the collateral for the loan. Once long-term financing is available, it is used to pay back the bridge loan and also meet other capitalization needs. Bridge loans are mainly used in real estate to retrieve property from foreclosure or to close on a property quickly.
Types of Bridge Loans
1.First Charge Bridging Loan
A first charge bridging loan gives the lender a first charge over the property. If there is a default, the first charge bridge loan lender will receive its money first before other lenders. The loan attracts lower interest rates than the second charge bridging loans due to the low level of underwriting risk.
2. Second Charge Bridging Loan
For a second charge bridging loan, the lender takes the second charge after the existing first charge lender. These loans are only for a small period, typically less than 12 months. They carry a higher risk of default and, therefore, attract a higher interest rate. A second charge loan lender will only start recouping payment from the client after all liabilities accrued to the first charge bridging loan lender have been paid. However, the bridging lender for a second charge loan has the same repossession rights as the first charge lender.
3. Open Bridging Loan
The repayment method for an open bridge loan is undetermined at the initial inquiry, and there is no fixed payoff date. In a bid to ensure the security of their funds, most bridging companies deduct the loan interest from the loan advance. An open bridging loan is preferred by borrowers who are uncertain about when their expected finance will be available. Due to the uncertainty on loan repayment, lenders charge a higher interest rate for this type of bridging loan.
4. Closed Bridging Loan
A closed bridging loan is available for a predetermined time frame that has already been agreed on by both parties. It is more likely to be accepted by lenders because it gives them a greater degree of certainty about the loan repayment. It attracts lower interest rates than an open bridging loan.
How Do They Work?
A bridge loan is used in the real estate industry to make a down payment for a new home. As a homeowner looking to buy a new house, you have two options.
The first option is to include a contingency in the contract for the house you intend to buy. The contingency would state that you will only buy the house after the sale of your old house is complete. However, some sellers might reject this option if other ready buyers are willing to purchase the house instantly.
The second option is to get a loan to pay a down payment for the house before the sale of the first house goes through. You can take a bridge loan and use your old house as collateral for the loan. The proceeds can then be used to pay a down payment for the new house and cover the costs of the loan. In most cases, the lender will offer a bridge loan worth approximately 80% of the combined value of both houses.
Business owners and companies can also take bridge loans to finance working capital and cover expenses as they await long-term financing. They can use the bridge loan to cover expenses such as utility bills, payroll, rent, and inventory costs. Distressed businesses can also take up bridge loans to ensure the smooth running of the business, while they search for a large investor or acquirer. The lender can then take an equity position in the company to protect its interests in the company.
