What is a Bridging Loan & how do they work?

If you’re looking to move houses then you’ve probably heard of the term “bridging finance”. We break down exactly what a bridging loan is, and how a bridging loan works.

A bridging loan is when you require finance to purchase a second property with the intention of selling the existing one. A bridging loan is typically an interest only payment home loan with a limited loan term. The extent of the bridging loan is calculated on the equity in your current property.

It is an additional home loan that you take out on top of your current home loan until the property is sold and the loan can be closed. This means during the bridging period you have two loans and both loans are being charged interest.

Some loan structures only require you to make repayments on your original loan until settlement. During the bridging period, the interest on the bridging loan gets added to your ongoing balance on your bridging loan but you don’t have to make repayments on it until your existing property is sold. Other loan structures require you make payments on both loans from the time you open the new loan.

When your current home is sold, the bridging loan is converted into your chosen home loan for your new property.

It should be noted the interest is compounded monthly, which means the longer it takes to sell your property, the more interest that will accrue. You will also need to check the bridging period, which is usually six months for purchasing an existing property and 12 months for a new property, as lenders can charge a higher interest rate if you don’t sell your property within this time frame.

 

WHAT BRIDGING LOANS ARE AVAILABLE?

You generally have the option between closed bridging loans or open bridging loans.

Closed bridging loans

This is a loan based on a pre-agreed date your property will be sold by, meaning you can pay out the remaining principle of the bridging loan. This is suited to consumers who have already agreed on the sale terms of their property. These loans generally pose less risk to the lenders as the sale has been locked in.

Open bridging loans

This is a loan where the sale of the property has not been finalised, and the property may not yet be on market. It is generally used by homebuyers who have found their ideal property and want to make an offer, but haven’t yet sold their existing property. These loans pose greater risk to lenders and the consumer will likely be asked more questions including proof their house is on the market. To take out an open bridging loan, you will generally need more equity in your property and it is a good idea to have a back up plan in case the sale of your house doesn’t proceed as planned.

 

WHY WOULD YOU GET A BRIDGING LOAN?

By taking out a bridging loan, you can avoid the stress of trying to match up settlement dates, which gives you a better chance of selling your existing home at a reasonable price without time pressure.

In a perfect world, it would be possible to sell your existing home and buy a new home on the same day – but as it is, we currently have a cooling-off period during which the buyer has to arrange finance to buy their new home before settlement day.

The reality is that there’s a certain amount of uncertainty in the housing market and bridging finance allows people to buy a new home while they are waiting for their current home to be sold.

Borrowers can usually also add the upfront costs of buying a home to a bridging loan, such as stamp duty, legal fees, and inspection fees.

However, please note that bridging finance may not be available or suitable for every borrower. Lenders often require that you have a certain amount of equity in your existing home so you can provide a substantial deposit on your new home to have a lower LVR. Or lenders may require that borrowers without equity in their existing home pay a higher interest rate on their new home’s bridging loan.

 

HOW DOES A BRIDGING LOAN WORK?

When you take out a bridging loan, the lender usually finances the purchase of the new property, as well as taking over the mortgage on your existing property.

The total amount of finance borrowed is known as the ‘Peak Debt’, and is generally calculated by adding the value of your new home to the outstanding mortgage from your existing home. By then subtracting the likely sale price of your existing home, you’ll be left with the ‘Ongoing Balance’ and this will be the overall balance of the new loan.

During the bridging period, interest will be compounded monthly on your ongoing balance at the standard variable rate.

Some lenders do not charge higher interest rates on bridging loans than on other types of home loans, but it’s vital that you compare your options.

 

BRIDGING LOAN EXAMPLE SCENARIO

The diagram below shows an example of the sale and purchase process in a bridging loan scenario.

Say the balance of the loan on your existing property is $200,000 and the funds required for the new property are $500,000. You may be able to borrow up to $700,000, which will be your Peak Debt.

The purchase process for an example bridging loan scenario:

You now have a short term debt of $700,000, on which interest is payable, while you wait for the sale of your existing property.

If you’ve opted to capitalise the interest that accrues on the Peak Debt (assuming your lender offers this feature), the debt will continue to increase until you either start making repayments, or the sale of your existing property is completed.

To keep the numbers simple, let’s say in this example that you’ve been paying the interest and your Peak Debt remains at $700,000.

If the net proceeds of the sale of the existing property are $400,000 and you put that full amount towards the Peak Debt, then you will be left with an End Debt of $300,000 (that is $700,000 less $400,000).

The sale process for an example bridging loan scenario:

From this point on, you’re just on a standard mortgage product with regular repayments.

 

REQUIREMENTS FOR A BRIDGING LOAN

There are a few requirements that may apply to bridging loans that wouldn’t apply to other types of home loans. With many lenders, criteria applies such as:

  • Maximum LVR requirements can apply, meaning you need a deposit of a certain amount in order to apply, e.g. a 25% deposit.
  • Maximum loan term can apply to bridging loan, e.g. your current home needs to be sold in 6-12 months.
  • Not usually allowed to use a redraw facility on the bridging loan during the bridging term.
  • Not usually available for construction loans.
  • Not usually available for company purchases or strata title purchases.

 

THE PROS & CONS OF BRIDGING LOANS

It’s important to look at the pros and cons of bridging loans, because like any financial option, it’s important to do your research and compare your options before diving in. We can help you there.

THE PROS
  • Convenient: Bridging loans ensure you can buy your property straight away because you don’t have to wait for your current home to sell.
  • Repayments: During the bridging period, you only make repayments on your current mortgage.
  • Avoid renting: You can avoid the costs and hassle of having to rent a home in the period between the sale of your existing home and settlement of your new home.
THE CONS
  • Valuation cost: Bridging finance may require two property valuations (your existing property, and the new property), which means two valuation fees
  • Interest: Interest is usually charged on a monthly basis, so the longer it takes to sell your property, the more interest your new loan will accrue.
  • Interest rates: If you don’t sell your existing home within the bridging period, you will typically be charged a higher interest rate.
  • Termination fees: If your current home loan lender doesn’t offer a bridging loan, you’ll need to switch, which may result in early exit fees from your current loan (especially if you’re switching during a fixed interest rate period).

 

COMPARE HOME LOANS WITH THE LOAN ROOM

Our team compares more than 4,000 home loans, helping you find the right product for your needs. If you’re looking for a new house or home loan, get in touch!

 

 

Source: Canstar