How does a bridging loan work?

After months of scouring the real estate market you’ve finally found the perfect home at a price you’re happy with. You want to snap it up before someone else does. But what do you do if you haven’t yet sold the house you already own which has its own mortgage attached? One option available is a bridging loan.

What is a bridging loan?

A bridging loan, also referred to as bridging finance, is a special type of short-term loan designed to cover the purchase price of a second property and give you time to sell your existing property, even if you already have a mortgage. It essentially creates a financial ‘bridge’, allowing homeowners to traverse the gap between buying and selling. However, there are many aspects to this type of loan that may need to be considered before signing on the dotted line, such as interest costs and conditions.

Canstar’s Data Insights Director Sally Tindall, said bridging loans could be considered by some people when transitioning from one home to another but should be approached with a healthy dose of caution, since you’re essentially paying interest on two loans at once.

“Spend some time exploring the alternatives. Can you ask for an extended settlement on the new property, to give you time to sell your current home? Is it worth putting your house on the market first, to give you a clearer idea of how long it will take to sell and how much it’s likely to sell for?” she said.

“These types of loans are typically interest-only and usually run for a maximum of 12 months, sometimes at higher-than-normal interest rates.”

“A shift in the market dynamics could also throw a spanner in the works and add to the time it takes to sell your existing property, stretching from days to weeks and potentially even months.”

Ultimately, she says to do the maths on each different option before making a binding decision.

How do bridging loans work?

A bridging loan is typically an additional loan that you take out on top of your existing home loan. This means that during the “bridging period” while you’re trying to sell your old property, you have two loans and are generally being charged interest on both of them.

Typically, a bridging loan:

• is a type of interest-only home loan,

• has a value that is calculated according to the equity in your current property,

• has a limited loan term,

• and carries special conditions, such as a lender being able to charge a higher interest rate if the property is not sold within a certain timeframe.

The way bridging loans are structured can differ from lender to lender:

• Some loans only require you to make repayments on your original loan until the settlement of your new property. When your existing property is sold, and the original mortgage is discharged, you then start making repayments on the principal of that bridging loan (plus the added interest).

• Other loans may require you to make payments on both loans from the time you open the new loan.

When your current home is sold, the original mortgage is discharged and the bridging loan is then often converted into your chosen home loan for your new property.

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Potential pros and cons of bridging loans

It’s important to look at the pros and cons of bridging loans, because like any financial option, it’s often worth doing your research and comparing your options before diving in.

Pros of bridging loans

• Convenience: Bridging loans could help ensure you can buy your property straight away without having to wait for your current home to sell.

• Potential to avoid some repayments: Depending on how your loan is structured, during the bridging period you may only need to make repayments on your current mortgage.

• Potential to avoid renting: If the timing is right with the bridging loan and the sale/purchase, it could be possible to avoid the costs and hassle of having to rent a home in the period between the sale of your existing home and settlement of your new home.

Cons of bridging loans

• Risk of cost blowout: If you don’t sell your home or sell it for a price that’s not high enough in the required time, you could be left with a large interest bill, or risk the bank stepping in to sell your home. If your property sells for less than you expect, you could also be left with a larger ongoing loan amount, which could risk putting you into financial difficulty. It could pay to have a back-up plan.

• Potential expense of two loans: Bridging finance may require two property valuations (your existing property and the new property), which could mean two sets of valuation fees, as well as other fees and charges for the extra loan.

• Potential interest charges: As with any loan, the longer it takes you to pay it off, the more interest you will be charged. If you have trouble selling your property, you’ll tend to pay more interest on your bridging loan repayments as each month goes by. In addition, if you don’t sell your existing home within the bridging period, your loan will typically revert to a higher interest rate.

• Potential termination fees: If your current home loan lender doesn’t offer a bridging loan, you’ll need to switch and refinance, which may result in early exit fees from your current loan (especially if you’re switching during a fixed interest rate period).

It’s important to always read the Key Facts Sheet (KFS), Product Disclosure Statement (PDS) and Target Market Determination (TMD), as well as other loan documentation, before making a purchase decision.

Alternatives to bridging loans

A bridging loan is not the only option to consider when buying a new house before selling your existing one. Other options could include:

• Altering the purchase contract: Depending on your circumstances, it might be possible to add a “subject to sale” clause on the contract for your new home. This means that the contract on your new home wouldn’t become unconditional until you sold your existing home. Consult a qualified professional for advice before considering this option.

• Negotiating a longer settlement period on your new home: This could allow you some extra time to sell your existing home before your loan for the new one begins.

If you’re considering taking on a bridging loan, it could be worth seeking out financial advice from a suitably qualified professional.

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What bridging loans are available?

Lenders in Australia generally offer two choices – closed bridging loans or open bridging loans.

Closed bridging loans

This is a loan based on a pre-agreed date your property will be sold by, after which time you can pay out the remaining principal of the bridging loan. For example, this could be suited to borrowers who have already agreed on the sale terms of their existing property and know what date their contract for sale will settle.

Open bridging loans

This is a loan that does not have an agreed settlement date, but instead a general loan term (typically six or 12 months). This type of bridging loan could be useful for someone who has not yet found a buyer for their existing home. It’s likely that a lender will ask for extra details when taking out this loan, such as proof that the original property is on the market.

What to consider with bridging loans

• Bridging finance may not be available or suitable for every borrower. Lenders often require that you have a certain amount of equity in your existing home so you can provide a substantial deposit on your new home to give you a lower Loan to Value Ratio (LVR). Alternatively, some lenders may require that borrowers without equity in their existing home pay a higher interest rate on their new home’s bridging loan.

• Due to the power of compounding interest – which would likely be doubled in this case due to having two loans – the longer it takes to sell the old property, the more interest will accrue and the more you will have to pay for the loans.

• The length of the bridging period, which is usually six months for purchasing an existing property and 12 months for a new property, should be taken into consideration. Lenders typically include conditions in the loan allowing them to charge a higher interest rate if you don’t sell your property within the stated time frame.

• It’s important that you understand the loan and its conditions, and read any relevant information – such as the Product Disclosure Statement (PDS), Target Market Determination (TMD) and Key Facts Sheets (KFS) – before signing on the dotted line. Consider seeking suitably qualified financial and legal advice.

When considering a bridging loan, it’s handy to be familiar with a few key elements:

• One lender typically provides both loans: When you take out a bridging loan, the lender typically provides finance for the purchase of the new property, as well as taking over the mortgage on your existing property. The lender may also change the status of the original loan, such as shortening the term, or give you the option of changing to interest-only repayments. There could be costs involved with this process, such as fees and charges for loan alterations.

• What you then owe is called “Peak Debt”: This is the term typically used to describe the total amount of money borrowed from that lender, for the short period of the bridging loan. It’s generally calculated by adding what you need to borrow to buy your new home to the outstanding mortgage on your existing home.

• During the bridging period, your repayments are likely to change: The repayments could include payments on one or both loans.

• When you sell your existing home, the amount left is called the “Ongoing Balance”, or “End Debt”: By then subtracting the likely sale price of your existing home from your Peak Debt, you’ll be left with the ‘Ongoing Balance’ – the overall balance of the new loan.

• After you sell your home, your loan will revert to another product: The lender may offer, or require, the loan to be converted into another type of loan – such as a standard fixed-term loan or one with principal-and-interest repayments – when you settle the mortgage on your original house.

• On the new loan, your repayments will be different: The amount you will be required to pay the lender in repayments will probably be different to your payments made before you took the bridging loan, and to your repayments made during the bridging period.

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What are the requirements for a bridging loan?

There are a few requirements that may apply to bridging loans that wouldn’t apply to other types of home loans. Depending on the lender and specific product you choose, some of the criteria and considerations that could apply include:

• Maximum LVR requirements mean that you may need a deposit of a certain amount in order to apply. Some lenders may also require you to have a minimum level of equity in your existing home, such as 20% of the peak debt.

• Maximum loan term on the bridging loan means that your current home may need to be sold in 6-12 months.

• You may not be allowed to use a redraw facility on the bridging loan during the bridging term.

• Bridging loans may not be available for company purchases or strata title purchases.

What are some tips for people who decide they need bridging loans?

Canstar’s Data Insights Director Sally Tindall has some tips for people who decide that they need a bridging loan:

• If you are thinking about a bridging loan, make sure you own a solid amount of equity in your current home to support the financing.

• Shop around to understand your options. Find out what rates and fees your existing lender will charge but see if others will offer you a decent rate. Your options could be limited – most lenders offer bridging loans to their existing customers but not to new ones.

• Get a valuation of your existing property and be realistic about how much you can sell it for.

• Have a back-up plan in case your home doesn’t sell as quickly as expected.

When is the best time to sell your house?

If you have the means to prepare before selling your existing home, you might want to think about what the best time would be to do so. Just like our yearly seasons, the property market also sees seasonal change throughout the year. Generally, spring time (September to November) is the most popular time to sell, often with the highest number of sales for the year coming in this period. There are benefits to selling outside this busy period and opting for a quieter season like winter though. You’ll often have more potential buyers see your home, as there are fewer properties on the market to choose from.

Property experts will often talk about ‘market conditions’ when talking about the overall property market. These conditions are usually either a buyer’s or seller’s market. As the name suggests, a buyer’s market is when there are more houses available than the number of people looking to buy them. During a buyer’s market, sellers are often advised to be patient, as well as realistic about the overall sale price. A seller’s market, on the other hand, is when the demand for houses is greater than the amount available on the market. Houses are more likely to sell quickly during a seller’s market and often with a better overall sale price.

To work out whether the market is currently a buyer’s or seller’s, you can track the weekly property sales in your property’s local area, paying attention to the speed in which properties sell and the prices in which they sell for. You can also stay up to date with the wider economy and interest rate movements by reading the latest articles from Canstar, as well as by listening to finance specific podcasts or listening and/or watching the latest finance news. Determining when the best time is for you to sell will ultimately come down to your own personal circumstances.

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