Buying before selling: Could a bridging loan help?

After months of scouring the real estate market, you’ve finally found the perfect home at a price you’re happy with and 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 to consider could be a bridging loan.

A bridging loan 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 Money Expert, Effie Zahos, said bridging loans can be very handy for some people when transitioning from one home to another but they come with their own risks and costs.

“Generally you’ve got six to 12 months to sell your old home until the bridging loan is pulled from you, unless the equity can enable the remaining balance to go to the new property,” she said.

“With that in mind, you have to be certain market conditions are in your favour – does your house have that wow factor to help it sell? Is the suburb on the rise or on the fall?

“12 months go very quickly and you could find yourself forced into selling your original property at a lower price than you were hoping just to meet the conditions of your bridging loan.”

What is a bridging loan?

A bridging loan is typically an additional loan – one you take out on top of your existing home loan. This means 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
• 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 loan structures only require you to make repayments on your original loan until settlement at your new property. During the bridging period, however, the interest on the bridging loan gets added to the ongoing balance of your bridging loan. 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 loan structures 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.

It is important to note that 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, generally speaking. Interest is calculated daily and could be charged monthly, so this could add up quite quickly, depending on the amount you’ve borrowed.

It could also pay to consider carefully the length of the bridging period, which is usually six months for purchasing an existing property and 12 months for a new property. 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. And, as one lender states, there is the possibility that if you don’t sell your property, the lender “may get involved to sell the property” in order to settle the loan.

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 important to do your research and compare your options before diving in.

Lenders who offer these types of bridging loans list a number of possible pros and cons:

Pros of bridging loans

• Convenient: Bridging loans could help ensure you can buy your property straight away without having to wait for your current home to sell.
• Repayments: Depending on how your loan is structured, during the bridging period you may only need to make repayments on your current mortgage.
• 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 if you don’t sell or sell for a price that is not high enough: If you don’t sell your home 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.
• Loan costs: Bridging finance may require two property valuations (your existing property and the new property), which could mean two valuation fees, as well as other fees and charges for the extra loan.
• Interest/interest rates: Interest is usually charged on a monthly basis, so the longer it takes to sell your property, the more interest your new loan will tend to accrue. In addition if you don’t sell your existing home within the bridging period, you will typically be charged a higher interest rate.
• Termination fees: If your current home loan lender doesn’t offer a bridging loan, you’ll need to switch, 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 and other loan documentation, as well as the lender’s terms and conditions, 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 are considering taking on a bridging loan, it could be a wise idea to also consider seeking financial advice from a suitably qualified professional.

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 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, for example. 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.

However, please note that 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.

How does a bridging loan work?

When it comes to understanding how bridging loans work, it’s important to know a few key elements:

1. 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 (it could pay to check with your lender), 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.
2. 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 is generally calculated by adding what you need to borrow to buy your new home to the outstanding mortgage on your existing home. So for example, if you needed to borrow $650,000 to buy your new home and you still had $300,000 owing on your existing mortgage, your “peak debt” would be $950,000.
3. During the bridging period, your repayments are likely to change: As discussed earlier, the repayments could include payments on one or both loans (check the conditions of the bridging loan with your lender before signing up).
4. 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. For example, if you have a Peak Debt of $950,000 and sell your existing property for $500,000, your Ongoing Balance or End Debt would be $450,000.
5. After you sell your home, your loan will revert to another product: The bank 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. It could be a good idea to ask your bank what loan conditions and interest rate would apply after the bridging loan period.
6. On the new loan, your repayments will be different: The amount you will be required to pay the bank in repayments would probably be different to your payments before you took the bridging loan, and to your repayments during the bridging period.

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, meaning you may need a deposit of a certain amount in order to apply, e.g. a 25% deposit. 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, e.g. 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.

It’s important to note that the economic fallout from the COVID-19 pandemic has changed the way many lenders are considering home loan applications. This could result in delays to processing times and stricter lending conditions, depending on your circumstances and the lender you choose.

Cover image source: Hien Phung Thu / Shutterstock.com