If you’re looking for a new home, you might have encountered lenders discussing the concept of a bridging loan. With so much to remember when moving from your current home to a new property, understanding bridging finance can help you transition seamlessly between home loans.
What is a bridging loan?
A bridging loan is an interest-only short-term loan, also called bridging finance.
This is used when you have an existing home loan and are looking to move to a new house, covering the gap for this bridging period between home loans. Since home buyers can struggle with the hassle of moving to their next home with much of their money tied up in their first home equity, the purchase of a new property can be complicated without taking out a new loan.
There are a few different types of bridging loans, but most have loan terms between 6-12 months as you transition from your current property to a new property. The loan amount will often be calculated using the available equity on your existing property. Repayments are made once you have sold your old home.
Since bridging loans rely on your ability to find a new home within the bridging period, the interest rate on the loan may increase if you do not find your dream home in the specified period. Likewise, you might pay a higher interest rate if you need to extend the timeframe to pay off your bridging loan.
As bridging loans are short-term, they tend to have fixed rates rather than variable rates, but you should check the comparison rate to find the most accurate idea of the interest rate you will pay.
How does a bridging loan work?
Let’s look at a practical example of how a bridging loan works in Australia.
A common use of a bridging loan would be a homeowner looking to move from their old home worth $700,000. Their loan-to-value ratio (LVR) is currently 60%, which means they’ve paid off 40% of their loan ($320,000) and have a remaining loan balance of $480,000.
The purchase price of the real estate they’re looking to buy is $900,000, but it’s for sale before they’ll be able to close out their existing mortgage.
Generally, what will happen is that their existing $480,000 loan balance will become their bridging loan for 12 months. They will use this until their equity is released from their first home.
They can then begin the refinancing process for a new loan, either transferring over their existing home loan or taking out a new loan if the timing is too much of a hassle. They can then seek a home loan with a lower interest rate and the loan features that suit them, provided they meet the eligibility and lending criteria.
Over the 12 months, they will make interest-only repayments on this bridging loan.
The combined total maximum loan of the bridging loan and the home loan is referred to as peak debt.
There are different types of bridging loans, including:
- Closed bridging loans: These are used when the settlement dates for the sale of your existing property don’t align with the purchase of your new home.
- Open bridging loans: Open bridging loans are used when a new property has not yet been purchased.
If you aren’t sure which product is right for you, check the target market determinations (TMD) and product disclosure statements (PDS).
Advantages of taking out a bridging loan
By taking out a bridging loan, borrowers can avoid falling into difficult financial situations where they cannot transition from one property to another.
This can mean they have a large enough deposit to avoid paying lenders mortgage insurance (LMI). This is a charge on borrowers who pay a deposit below 20% to cover the lender if borrowers cannot make their repayments.
It also means that borrowers may gain access to home loans they would have been blocked from with their equity tied up. This could open up their eligibility for home loans with features like offset accounts and redraw facilities.