If you already own a home, you can sell it, and use the proceeds to fund the down payment and closing costs. You can arrange it to have both the sale and purchase closed on the same day. Alternatively, you may not wish to wait until your house sells to buy a new one.
One option is to obtain a bridge loan, or a short-term loan to fill the financing gap.
How it works
You have found the perfect home. However, you have not sold your existing property yet, which likely presents a funding problem. Hence, a bridge loan comes into play. You are “bridging” the gap between buying a new property and selling your old one. This is an option you can use to obtain cash that you can utilize to pay the down payment and closing costs on your new home, before selling your existing property.
In essence, the lender uses the equity in your existing home as collateral, even though you have not sold it yet. For instance, if your home is worth $800,000 and you have an existing $350,000 mortgage, you may borrow $200,000 to cover your financing on the new property. There is an additional wrinkle, though. Typically, your borrowing is limited to 80% of the value of both homes.
Bridge loans are designed to exist for a short period, generally only a few months.
If you are approved for a bridge loan, you could drop the mortgage contingency clause from your offer. This can make it stronger, although we advise proceeding with caution, including retaining the contingency if the lender rejects your mortgage due to factors related to the building.
You do not risk losing out on a great home since you do not have to wait until your existing property sells to purchase a new one. However, we caution that you should utilize a bridge loan only in cases where you are highly confident your home will sell quickly.
You are basing the decision on the premise that the housing market remains strong. This can change quickly, however. Bridge loans were accessible in the years leading up to the 2007-2008 housing crash. Should the situation change rapidly, you are in a difficult position since you are paying a higher loan balance on two homes.
You are also likely to pay a higher interest rate on a bridge loan than a conventional mortgage.
What else you need to know
Since the loans are riskier, banks require the borrower to have excellent credit. This includes a low debt-to-income ratio and a high credit score. Lenders are also going to want to see that you have a lot of equity in your existing home.
Your risk is mitigated somewhat if you have a lot of equity in your home and you are purchasing a less expensive place. If you have strong financials such as a high income and little debt, a bridge loan can work in your favor. Still, it is essential to understand the risks before entering into a bridge loan, and if you are not comfortable, you should not do it.