What is a Bridging Loan?

Do you need funds to snap up a property before you’ve sold your home? If so, you might be considering a bridging loan. But what is a bridging loan? And is it a good idea?

The answer to that will depend on your circumstances. We’re going to look at how bridging loans work. And we’ll explore the pros and cons to consider before deciding whether a bridging loan is right for you.

Let’s get started.

What is a bridging loan, and how does it work?

A bridging loan is designed to bridge a financial gap. It’s usually a short-term solution when another funding source is coming in the future but hasn’t yet arrived. 

It’s often used to pay for property, whether by developers or people looking to buy a home. About a fifth of bridging loans are taken out to prevent breaks in property chains.

But how does a bridging loan work? 

An asset is used as security against the bridging loan, meaning it’s at risk if you don’t repay the loan. The asset could be one property or several. 

The amount you can borrow depends on the value of the asset. You’ll usually be able to borrow up to 75 per cent of your equity in the asset (equity is the amount of the asset you own outright). That figure includes any borrowing to pay the interest on the loan.

The interest rate applies monthly (rather than annually, as for a mortgage). And in most cases, the interest is added up and repaid in one hit at the end of the loan period.

Example of how a bridging loan works:

You want to buy a new property that costs £400,000.
You’re going to have a mortgage of £340,000, and need to pay a deposit of £60,000. You have £10,000 in savings. And you plan to use the proceeds from the sale of your current home to pay the remaining £50,000.
Your current home is worth £200,000, and you have a mortgage of £100,000 on it. That leaves you with equity of £100,000.
You already have a buyer for your current home, and you’ve exchanged contracts. But you haven’t completed the sale, so you don’t yet have the money.
You decide to take out a bridging loan at 1.5% interest for the £50,000 you need. You secure the loan against your current home.
One month later, the sale of your current home is completed. You repay the bridging loan of £50,000, plus one month’s interest of £750. (You’ll also have other fees to pay — more about those later.)

What is the purpose of a bridging loan?

As in the example above, a bridging loan is designed to provide a stop-gap. It’s usually short-term — and if you borrow for longer periods, it can be very expensive.

So what is a bridging loan used for? Some typical examples are:

To enable buyers to secure a new home before completing the sale of their current property To enable a property to be bought at auction, where there isn’t time to get a traditional mortgageTo enable developers to “flip” properties, buying them and developing them for a profit which they can use to repay the loan.

Different types of bridging loan

There are two main types of bridging loans:

Closed bridging loans are for a specified period. They work best when you know there’s a fixed point at which you’ll have the money to repay them. An example would be when you’ve exchanged contracts with a buyer for your property and have a date for completion of the sale.Open bridging loans don’t have a fixed repayment date. They’re still short-term propositions, though, and you’ll usually be expected to repay them within a couple of years.

You’ll need a clear strategy to repay whatever type of bridging loan you take out. And that should include a Plan B if things don’t turn out the way you expect them to.

That exit strategy will be vital for convincing lenders that they’ll get their money back. But more importantly, it reduces the risk of losing the asset you’ve used to secure your loan.

What are first and second-option bridging loans?

Whether you get a first or second-option bridging loan depends on the asset you’re using as security.

If it’s a property that’s already mortgaged, your existing mortgage provider will have the first claim on it if you can’t repay your debts. In other words, the mortgage is the first charge loan.

Any funds left over after repaying the mortgage can then be used for other debts. That would make the bridging loan a second charge loan. And in most cases, you’ll need the consent of the first charge lender to add a second charge to the property.

But if there’s no mortgage on the property you’re using as security, the bridging loan could be the first charge loan. That usually means it will come with lower fees and interest rates.

What are the pros of a bridging loan?

That’s the different types of bridging loans explained! But are they a good idea?

Well, they do have some advantages:

They can be used to raise large amounts of money. Bridging loans typically start at about £5,000, but tens of millions of pounds can be made available. They can be used to raise funds quickly. That makes them great for people who need a fast solution, such as buying a property at auction.You can choose different repayment terms. That includes the length of time you’ll repay the loan and how you will repay the interest.Bridging loan providers may be more flexible than high street banks or building societies in the type of assets they’re prepared to accept as security.

What are the cons of a bridging loan?

Bridging loans are high risk, though. And there are several disadvantages you need to know:

You could lose the asset you’ve used to secure the loan. If you can’t repay it, the asset will be seized. And if you’ve secured the loan against your home, you’re in serious trouble.

Interest rates are high. Because they’re short-term, advertised rates are applied to the whole loan amount monthly. So even loan rates that look low will have a much higher APR (annual percentage rate) than a traditional mortgage. The 1.5% interest rate in our example would equate to an APR of at least 18%.You’ll need to pay fees too. These will include an arrangement fee (usually about 2% of the loan value), a property valuation fee, and probably an administration fee when you repay the loan.

Is bridging finance a good idea?  

Bridging finance comes with high risks. But it can be a valuable source of funds in certain circumstances.

Here are some questions to ask yourself before you make a decision:

Do you have a clear exit strategy to repay the loan? How certain are you that it will work? What would you do if something unexpected happened (like a buyer dropping out of a purchase)? Remember that if you have a closed bridging loan, you won’t have any flexibility on the repayment date.Can you afford the costs of the loan? That includes interest and all the fees. If you choose an open bridging loan, every month you don’t repay it will cost you big money. And with a closed loan, you may be faced with fees if you want to repay it early.Are there lower-risk options that would suit you better? Remortgaging your current home will almost certainly give you a lower interest rate. Or you could consider a let-to-buy mortgage, where you rent out your existing property to cover repayments on a new mortgage.

How do I apply for a bridging loan?

If you’re satisfied that a bridging loan is the right option, finding a specialist broker can be a good idea. High street banks don’t generally offer bridging loans, and a broker may be able to access a wider range of deals.

Look for providers who are members of the Association of Short-Term Lenders. They have signed up to a strict code of conduct covering the way they do business.

Be ready to provide them with the following:

Information on how much you want to borrow and for how longYour plan to repay the loanEvidence that the mortgage will be accepted (if you’ll be using a mortgage to repay the loan)

Recap: what is a bridging loan? 

So what is a bridging loan? Well, it isn’t for everyone. It’s a high-risk option, and it’s sometimes referred to as a “loan of last resort”.

But in some circumstances, it can be a helpful solution to a short-term cash flow problem. Make sure you fully understand how much the loan will cost and have a clear plan to repay it. If you don’t, you could find your home is at risk.

Also read:
How long does a mortgage offer last? 
What happens on completion day?
Where are the best places to buy to let in the UK?