What is a Bridge Loan? - dummies

By Eric Tyson, Robert S. Griswold

What is a bridge loan? Some believe it’s the answer to buying your second home. It’s highly unlikely that you’ll remain in your first home forever. Sooner or later birth, death, marriage, divorce, job transfers, retirement, or another monumental life change will probably force you to confront the eternal seller’s quandary — should you sell your present house before buying a new one or buy first and then sell?

There are, of course, risks associated with either course of action. However, you should know that it’s ultimately far less perilous to either sell your current house before buying a new one or to sell your house concurrently with the purchase of your next dream home. You’ll also sleep a whole lot better.

Why? Because, if you’re like most people, you can’t afford the luxury of owning two homes simultaneously. You have to use the proceeds from the sale of your present house to acquire your next home. That’s how things work in the real estate food chain.

Unfortunately, some folks create serious problems for themselves by purchasing a new home before their old one has sold — which brings us to bridge loans, an uncommon type of balloon loan that enables qualified borrowers to pull a portion of the equity out of their house before it sells. This financial bridge provides enough cash to complete the purchase. Bridge loans are not a great option. If you’re not careful, they can be the fiscal equivalent of a dose of arsenic. Here’s why:

  • Bridge loans aren’t cheap. Because a bridge loan is usually a second mortgage or HELOC (home equity line of credit), its loan origination fee and interest rate will be significantly higher than the amount you’d pay for a conventional first mortgage. A bridge loan’s interest rate is directly related to the combined loan-to-value (LTV) ratio of the existing first mortgage on the house you’re selling plus the bridge loan.

    You’ll get the best possible interest rate on the bridge loan if you keep the total amount of your old house’s existing first mortgage plus bridge loan under 80 percent of the house’s fair market value. From a risk assessment standpoint, lenders know that their risk of loan default increases markedly when the LTV ratio exceeds 80 percent.

  • Your cash may drain away. You may think that your house will sell quickly. But if you’re wrong, you could end up owning two houses longer than you anticipated. How many months, for instance, can you afford to pay three mortgages (first mortgage plus bridge loan on your old house and first mortgage on your new home), two property tax bills, two homeowners insurance premiums, and two sets of utility bills? How long will you be able to continue maintaining two houses, especially if they’re located in two different towns? You may discover that you no longer own the houses — they own you. First, the houses will consume all your disposable income, and then they’ll gobble up your savings.
  • You could lose everything. If property prices decline while you’re trying to sell the old house, you may not be able to sell it for enough money to pay off the outstanding loans. In that case, the holder of the bridge loan may be able to foreclose on your new home to make up the shortfall.

Bridge loans are fine if you’re wealthy enough to afford owning two houses for an extended period of time. You can use a bridge loan in one other situation — if the house you’re selling has a ratified offer on it, if your transaction is currently in escrow, if all the conditions of your sale have been removed, and if the sale will be completed in four weeks or less. Even under these stringent conditions, a bridge loan is risky because your deal could fall through.

Like rattlesnakes, bridge loans should be approached with extreme caution. Consider them a last resort. Stifle the unseemly urge to obtain bridge financing so you can buy your dream home before selling your present house. A bridge loan could turn that dream into a nightmare.