What is a bridging loan and when is it used?

Amongst a wide range of financial products, banks also offer lesser-known items used in less standard situations. Despite being less popular than traditional mortgage or investment mortgages (Buy-to-let and Holiday-let), specialist products are important and it is worth being aware of their existence. One such unusual, but sometimes very useful tool is a bridging loan. In this article, we will explain exactly what this product is, when it is used and how it can be obtained.

Bridging loan

A bridging loan is broadly defined as a short-term mortgage loan granted in situations where a person or company needs quick cash while awaiting larger financing. In the context of mortgages, bridging loans are typically used to purchase a property before the previous one is sold. It is a kind of financial bridge between one transaction and another – hence the name bridging loan. A typical example of the use of bridging loans is the financing of bargain purchases, for example at bank auctions.

Bridging loans are short-term loans with interest-only repayments. This means that the loan is usually granted for a maximum of one or two years, although the loan periods are usually even shorter – loans taken out for several months are common. The period depends on how long the borrower estimates it will take to sell their previous property.

Interest rates on bridging loans are quite high — often as much as 0.8% per month (almost 10% per annum), which is much higher than standard mortgages (often around 5%). Of course, the interest rate depends on the customer’s creditworthiness, but the specific nature of this type of financing means that it will always be more expensive. This is due to the higher risk that the bank takes when granting such a loan. Let us not forget that the assessment of your creditworthiness and risk (underwriting) is also a cost that must be compensated for with interest.

A bridging loan, which allows you to purchase a home, must also be secured in some way. This means that if you have problems repaying the loan, the bank has the right to seize and sell one of the properties. There are usually three types of security:

• security on the old house;

• security on the new house;

• security on both properties.

In practice, the latter option is most often chosen. In this case, the bank takes less risk, which means it can lend a larger amount on better terms. However, it is worth remembering that theLTV of your bridging loan will usually not be able to exceed around 70% (depending on the lender). It is worth knowing that bridging loans are only regulated by the Financial Conduct Authority if they are secured by residential property occupied by the borrower or their family – in other cases, such protection does not apply.

However, situations in which the bank would take over the property are extremely rare – the short loan period and a large cash injection from the sale of the previous property minimise this risk. Even if problems arise, the bank has both an obligation and an interest in reaching an agreement with the customer and finalising the entire process without terminating the contract.

How does a bridging loan work?

To illustrate how a bridging loan works, let us use a simple example. It will refer to the most common situation in which such financing may be needed, i.e. the purchase of a new property before the sale of the previous one. In any other case, a bridging loan will work in a very similar way.

Let us assume that Mr Janusz wants to sell his house for £500,000 and buy another one for £600,000, but he does not have enough cash to complete the purchase. He therefore decides to take out a bridging loan, which will allow him to make the purchase immediately. While the old property is listed for sale, Mr Janusz moves into his new home, paying interest each month. When his old house sells, he will repay the bridging loan in full with the proceeds from the transaction. He will be able to obtain the remaining £100,000 through a standard residential mortgage, for example.

Do I need to prepare another deposit?

Like other mortgages, a bridging loan requires a deposit. This type of financing usually requires a higher value than regular mortgages – often at least 20%–25% of the property value, and often even 30%. People who have largely paid off their mortgage on their previous property are in a good position – in this case, the bank may consider this property as a deposit, so you do not need to provide additional cash. However, if you have only been paying off your current home for a few years, it may be impossible to obtain a bridging loan.

Does the ERC apply to bridging loans?

Another factor that may seem confusing is the Early Repayment Charge (ERC). This is a fee for early repayment of a loan, mainly applied to longer-term commitments. Since a bridging loan is a short-term loan, this fee does not usually apply. However, it is a good idea to check the terms and conditions of the agreement to be sure – sometimes the bank requires a small fee for early repayment (for example, when the loan is granted for 6 months and the borrower sells the property after 2 weeks), but this is quite rare.

If you are planning to take out a bridging mortgage and expect to sell your current property within a very short period of time, be sure to discuss this detail with your Extend Finance adviser.

How is creditworthiness assessed for bridging loans?

The assessment of creditworthiness for a bridging loan differs significantly from the classic assessment used for residential mortgages. Namely, in this case, there is greater emphasis on the so-called exit strategy, i.e. how the customer will be able to repay the loan.

An exit strategy determines how the customer will repay the debt. Most often, this involves selling the old house – the bank then makes an appropriate valuation of the property to determine whether the proceeds from its sale will be sufficient to cover the repayment of the principal, and analyses the property market in the given location to check its liquidity. If the property is located in an area that does not prevent a quick sale, the bank is more likely to make a favourable decision.

An exit strategy may also involve repaying a bridging loan with another mortgage (remortgage) – for example, if someone does not want to sell their previous property. In this case, the customer’s prospects for obtaining another loan are assessed.

The significant importance of the exit strategy in assessing creditworthiness does not mean that traditional methods, such as examining the customer’s overall financial situation and checking theircredit score, are irrelevant. These factors are also analysed, but in the case of bridging loans, they are of slightly less importance.

In what situations is a bridging loan useful?

As you might guess, the situation described earlier in this article is not the only one in which a bridging loan can be used. This financial product can also be used in other cases where quick financing is needed to enable a transaction to be completed. Below are a few examples:

• If you intend to purchase a property that requires renovation, you will not be able to obtain a traditional mortgage, as banks require the property to be habitable. In order to finance the renovation, you will first need to obtain a separate loan, for which a bridging loan is ideal. After the property has been renovated, you can repay the bridging loan with a standard mortgage, which the bank will only grant after the property has been valued following the renovation.

• Buying a property at auction – when someone decides to buy a house at auction, they have to act quickly. They will not be able to obtain a standard mortgage immediately, so they will use a bridging loan, which provides immediate cash to complete the transaction;

• Need for quick cash for investment – a bridging loan can be used as a regular mortgage-backed loan. For example, a self-employed person has received an attractive offer for equipment for their business that will allow them to increase profits. They can take out a bridging loan secured against their property and use the funds for the purchase. After a few months, he will repay the capital with the money he has earned.

Summary

A bridging loan is an interesting financial product that can help solve certain problems. It is a quick loan secured by real estate, which has a short loan period and does not require monthly capital repayments (interest-only). It allows you to combine various transactions and obtain mortgages in situations where this would normally be impossible.