Bridging Loans: What, How and Why.
In the world of finance, timing can often be a crucial factor. A bridging loan is designed to help property buyers and investors who need short-term financing to bridge the gap between two property transactions. This type of loan is particularly useful when someone needs funds to purchase a new property before the sale of an existing one is complete. In this month’s blog, we dive into what bridging loans are, how they work, the concept of peak and end debt, and why they can be a valuable option.
What Is a Bridging Loan?
A bridging loan is a short-term loan intended to cover a temporary financial gap. This type of loan is commonly used when a borrower wants to purchase a new property but has yet to sell their current one.
Typically, a bridging loan has higher interest rates than a traditional home loan due to its short-term nature and the additional risk taken on by the lender. However, it provides flexibility that can make a crucial difference in time-sensitive transactions. These loans are also generally interest only.
How Bridging Loans Work
Bridging loans are structured to help borrowers finance two properties simultaneously. Here’s how it works in practice:
The Loan Amount: The lender will determine your total loan amount based on the value of both your new and existing properties. This total is known as peak debt.
Peak Debt: Peak debt represents the sum of the existing mortgage balance on your current property, the cost of the new property, and any additional fees or interest accrued during the loan term such as stamp duty. This debt is typically the highest amount you will owe until the sale of the existing property.
End Debt: Once the current property is sold, the proceeds go toward reducing the overall peak debt. The remaining balance, known as end debt, is the amount that will transition into a traditional mortgage on the new property.
To simplify, the bridging loan covers your financial obligations until the sale of your existing property, after which the proceeds are used to reduce your debt. Any remaining end debt is then converted into a standard mortgage and depending on the lender, will generally have internal processes to convert the loan into a standard mortgage when the property is sold.
Why Would Someone Need a Bridging Loan?
Bridging loans are often beneficial for people in specific situations:
Purchasing a New Property Before Selling the Existing One: This is the most common use case. If a borrower finds a new property they wish to buy which is reliant on the equity of the existing property, but cannot complete the sale of their current property in time, a bridging loan can provide the necessary funds to secure the purchase. Other market alternatives include deposit bonds which can access equity from existing properties etc. to assist with initial deposits/contract exchange.
Renovating a Property: In some cases, property investors or homeowners may use bridging loans to finance renovations that increase the value of their property before selling it. This could maximize their profit and make their property more appealing to buyers.
The advantage of a bridging loan is that it provides temporary access to funds without requiring the immediate sale of an asset. This flexibility can be a lifeline in situations where timing is tight, or additional financial liquidity is required.
Key Considerations for Bridging Loans
Before diving into a bridging loan, there are some essential factors to keep in mind:
Interest and Repayment: Bridging loans often carry higher interest rates. Some lenders offer interest-only payments during the bridging period, while others offer interest capitalized terms, where the interest expense is taken from net loan proceeds and paid out when the existing property is sold.
Loan Term: Bridging loans typically have a short loan term, often between six to twelve months, though some may offer extended terms. It's essential to ensure that the sale of the existing property will complete within the loan term to avoid penalties. Lenders who also offer standard mortgage products (major bank and non-bank) will generally automatically convert any end debt into their standard mortgage product, however will require that you show loan affordability on the end debt to attain the bridging loan.
Property Valuation: The lender will require valuations on both properties, impacting the peak debt calculation. Property value fluctuations may affect your ability to secure the loan or impact your final debt amount.
Lending Amounts: Lenders often provide less funds for bridging loans based on available security. Major banks generally offer 70%LVR for ‘peak debt’ as an example and bridging loans do not exceed 80%LVR in the market/LMI is not offered for these loans.
Exit Strategy: An exit strategy is critical for bridging loans, as it assures lenders you have a plan to repay the loan. The sale of an existing property with no remaining end debt is the usual strategy for downsizing clients, however, for other scenarios, refinancing as an exit strategy is required should the lender not have an internal process of transferring the loan into a standard mortgage for any remaining end debt. This is triggered automatically as the lender needs to release the title of the property that you are selling and are therefore aware of when the property is sold and if any end debt remains.
Example Scenario of a Bridging Loan
Imagine you own a home with a mortgage balance of $200,000. You find a new property for $500,000 but are unable to sell your current home immediately. Here’s how a bridging loan would look in this scenario:
Peak Debt: The lender will calculate your peak debt as follows: $200,000 (existing mortgage) + $500,000 (new property) = $700,000, plus any accrued interest and fees such as stamp duty for the new property purchase and if interest expense was capitalized into the loan term.
Sale of Existing Property: Once your current home sells for, say, $300,000, you’ll use these funds to reduce the debt.
End Debt: After applying the sale proceeds, your end debt is reduced to $400,000 + fees. This amount is then refinanced into a traditional home loan on the new property. If initially, the bridging loan was written with a lender such as St. George, any end debt would transition into St. George’s standard variable product. Loan affordability would be calculated on end debt. If the loan term was then 1 year interest only (bridging loan period) and 29 years P&I (standard variable period assuming a 30 year term), loan affordability would need to be met for this scenario upfront for the $400,000 + fees end debt over a 29 year term.
Pros and Cons of Bridging Loans
Pros:
Enables the purchase of a new property without waiting for the current property sale.
Provides temporary access to a larger sum of money.
May offer interest-only or deferred payment options, easing short-term cash flow.
Cons:
Higher interest rates and fees than standard home loans.
Short-term loan duration may pressure borrowers to sell quickly or face higher costs.
Peak debt may be substantial, depending on valuations and accrued interest.
Is a Bridging Loan Right for You?
Bridging loans offer flexibility for those needing short-term financing to bridge the gap between two property transactions. They can be ideal if you need immediate funds but are confident in selling your current property quickly. However, understanding the structure, costs, and requirements is essential before committing and other market alternatives such as a deposit bond may be more suitable.
Bridging loans provide financial breathing room when timing and liquidity are crucial as a requirement for a bridging loan is 2 x Contract of Sales which the bridging loan period reflects. Generally at this stage, clients are pressured with set deadlines which may make traditional bank finance an unsuitable option. Whether moving to a new home, renovating, or needing short-term financing, bridging loans can make a difference in reaching your property goals effectively.
f you find yourself in need of a bridging loan, consulting with a financial expert can provide clarity on whether this type of loan suits your unique situation. At Loan Central Hub, we are finance experts who can match you with the best loan product for your finance requirements. Bridging loans, when managed well, can be a powerful tool to help you secure your next property without compromising on timing.
