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How do bridging loans work?

How do bridging loans work?
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A bridging loan is a type of secured short-term loan. It is typically taken out for a period of weeks or months while longer-term finance is arranged or expected funds become available.

Here, we tell you everything you need to know about these loans and how they work. 

How does a bridging loan work?

Bridging loans are most commonly used in relation to buying or investing in property.

Suppose you want to buy a new home but you need funds from the sale of your old home in order to complete the purchase. It’s taking longer than expected to sell your old home. This could be due to a delay in the formalities or because you have not yet found a buyer.

To avoid holding up completion of your purchase, a bridging loan could be a perfect solution.

The bridging loan essentially allows you to borrow money against your old home and use it as a deposit or payment for the new home. The expectation is that the sale of the old home will be completed shortly to enable repayment of the loan.

Essentially, a bridging loan can be used to bridge a shortfall of funding between buying and selling property. But it can also be also be used for other purposes including to:

  • refurbish a property and then sell it quickly
  • finish development
  • buy property at auction
  • purchase property that would not secure a mortgage in its current condition with a traditional lender

What types of bridging loan are there?

There are two types of bridging loan to consider.

Closed bridging loans

With this type of bridging loan, money is borrowed for a short and clearly defined period, perhaps a week or a month. You have a fixed repayment period and so the risks are quantified and limited.

Open bridging loans

Here, there is no fixed repayment date. However, you’ll normally be expected to pay off the loan within one year. Not surprisingly, open bridging loans are more expensive because they are flexible.

What are the typical terms of a bridging loan?

According to Which?, monthly interest rates are between 0.5% and 1.5% (which translates to an APR of between 6.1% and 19.6%). This is considerably higher than the rates of most other mortgage types.

There are also several fees which will add to the total costs. These include an arrangement fee (usually 1% of the sum advanced), a valuation fee, an admin fee, legal fees and and exit fee.

Due to the short-term nature of bridging loans, interest is calculated on a monthly basis instead of annually.

However, you do not have to pay interest every month. You can arrange for a rolled-up deal where you’ll pay all of the interest at the end of the term.

Or you can chose a retained interest deal. With this deal, when applying for a loan, you also essentially borrow the amount needed to cover the monthly interest payments. Then, at the end of the deal, you pay everything back at once.

How much can you borrow?

This will vary from lender to lender and depend on several factors. Your credit rating, the value of the property you are using as security and that of the property you are buying will all be considered. In the UK, bridging loans are typically for amounts from £25,000 to £25 million.

With some lenders, you can borrow up to 80% of the loan to value ratio (LTV). For others, you might be able to borrow 100% LTV if you can provide some other additional security.

What are the risks?

The main risk with bridging loans is that is they are very expensive. Many using bridging loans end up defaulting after underestimating just how expensive the interest can be. If you default several times, your debt can easily spin out of control because of the resulting fees.

The fact that you are relying on longer-term finance also presents a risk. If, for any reason, the finances do not come through as expected, you will be left with a very expensive debt. And it could get considerably bigger before you can secure alternative funding.

For these reasons, it’s a good idea to explore your options and see if there are cheaper and better alternatives out there before you commit yourself to this kind of funding. 

What are the alternatives to bridging loans?

One option is a buy-to-let mortgage. You can get funds for your new home by remortgaging your current home onto a buy-to-let mortgage and then using the released equity to pay for the new home.   

You could also explore another type of loan, such as a personal loan, to see whether it would be a cheaper and more convenient option.

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