By Alexandra Swann, GenEquity Mortgage and Member, CCAR’s REALTOR®/Lender Committee
With the summer home buying season drawing to a close, more and more buyers and their agents inquire about bridge loans. Sellers faced with multiple offers do not want to take an offer with a contingency to sell an existing home, and buyers often do not want to be faced with making two house payments. A bridge loan sounds like a great alternative—and for the right buyer, it can be.
How does a bridge loan work?
The term “bridge loan” can mean a couple of different things in the industry, so when talking to a loan originator, you need to be specific on exactly what you want. A bridge loan is a type of financing that eliminates the need for a contingent offer, making it easier to win a competitive bid. Since there is no contingency, bridge financing can help with shorter closing times.
Types of Bridge Loans
There are currently two popular uses of the term “bridge loan,” as well as a new third type—each with its own advantages and disadvantages.
Short-Term Home Equity Line of Credit
The first type of bridge loan is a short-term home equity line of credit against the equity in an existing home, which can then be used as the down payment on the new house. This is most common when the prospective buyer has a home with a lot of equity and a small first-lien balance or no balance at all. The new bridge loan is attached behind any existing first, and the buyer suddenly has access to the equity in the house.
This type of bridge loan can solve the problem of not having sufficient down payment because the funds to close on the new home are tied up in the current home. Home equity loans in Texas have no prepayment penalties, so when the house is sold, any first lien and the bridge loan are both paid in full. The only real expenses to the homeowner are any closing costs and the interest paid on the bridge loan during the months until the original primary sells. Also, the buyer is getting a permanent loan on the new primary immediately.
The buyer is making two house payments until the original home sells, which can deplete assets and strain income. In Texas, home equity loans are capped at 80% of the value of the property, so the borrower will not be able to access all of the equity. Most importantly, Texas cash-out loans are for primary residences only, so for a borrower to take out a home equity loan knowing that he/she is planning to immediately buy a new primary is dishonest.
The second type of bridge loan is a portfolio loan which is offered by several of the smaller regional banks. In this type of loan, there is no dishonesty because the lender understands that the loan is for the purpose of purchasing a new house. The lender qualifies the borrower and then orders two appraisals—one on the current primary and one on the new purchase.
Like the home equity loan above, this type of bridge loan can solve the problem of not having sufficient down payment because the funds to close on the new home are tied up in the current home. It is set up to have no prepayment penalties; when the house is sold, any first lien and the bridge loan are both paid in full. As before, the only real expenses to the homeowner are any closing costs and the interest paid on the bridge loan during the months until the original primary sells. Furthermore, the buyer is getting a permanent loan on the new primary immediately.
As with a home equity loan, the buyer is making two house payments until the original home sells, which can deplete assets and strain income. Most lenders of this type of bridge loan also cap the loan at 80% of the value of the property, but in some cases, the lender may go as high as 90%. This is very rare, however. Regardless, the borrower will not be able to access all of the equity.
The New Bridge Loan: A Short-Term Loan on the New Primary
The new, third type of bridge loan is not really a bridge loan, but because it is being sold to REALTORS® as a bridge loan, the REALTOR®/Lender committee felt we should include it here.
With this loan, the lender assesses the equity in the current home as the future down payment on the new primary and then makes a short-term loan on the new primary at 100% of the purchase price. The borrower does not have any payments on the new home for a set period of time—usually six months—while he/she is waiting to sell the prior home. The borrower is responsible for six months of interest payments, but these are generally “rolled” into the costs for the prior home. So when that home sells, the bank is paid, the lien is released, and the current home is refinanced into a new, permanent, fixed-rate mortgage.
The advantages of this type of financing are obvious. The buyer is able to purchase a new home without first selling the former home, without the financial pressure of two house payments, and without having to qualify with two house payments.
If for any reason the borrower’s prior home does not sell during the period set by the bank, he/she is going to be making two house payments plus interest. This could be a huge issue for a borrower who really does not have the financial resources to make both payments. Although we are accustomed to a red-hot housing market in most of DFW, remember that we have buyers coming in from all parts of the country, and those housing markets may be much cooler than ours. If the house being sold has not been priced or marketed properly, the buyer with the bridge loan may find themselves in a financially disastrous situation. Another major concern is that the qualifying situation may change during the period between the home purchase and the refinance of the new home. There are no guarantees that the buyer will qualify for the refinance, and the terms after the initial period can be quite onerous. The last major issue is that the buyer is not locking in the rate and terms of the permanent mortgage when buying the new primary residence. If rates rise or values decline, which are not unprecedented, it could be terribly painful for the buyer at the time of the refinance.
Determining if Bridge Loan is a Good Option
Bridge loans are simply tools; they are not inherently good or bad. Like most mortgage products, they are highly appropriate for some buyers and extremely inappropriate for others. No borrower should ever take a bridge loan if he/she really cannot afford to make two payments. If the buyer really does not have strong cash reserves or the income to support two house payments, that buyer needs to sell his/her house before buying a new one. Better to miss out on the perfect home today than to buy that home and be unable to make the payments nine months later. It’s always better to be safe than sorry.
For these and other questions about lending, contact the REALTOR®/Lender Committee at [email protected].