What are the pros and cons of bridging loans?

A bridging loan can be useful if you're caught between selling your current home and buying a new one. These short-term loans can provide the funds needed to purchase a new property while you wait for your existing home to sell. However, like any financial product, they come with both benefits and drawbacks.

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A bridging loan is a short-term loan that can help you bridge a brief gap in funding between two transactions, such as the purchase of a new home when the previous  one hasn’t sold yet.

Bridging loans are usually advanced for short terms of up to one year. You are only required to pay interest on the bridging loan until your house is sold, or the term of the bridging loan expires. Some lenders may even allow you to capitalise the interest on top of your bridging loan, so that you only need to make the principal and interest payments on the mortgage on your existing home during the term of the bridging loan.

Whether a bridging loan may be a suitable option for you will depend on several factors. Lenders usually charge a higher rate of interest on a bridging loan compared to a traditional home loan. As the interest is calculated on a daily basis, the longer it takes to sell your existing house, the more expensive a bridging loan will become for you. On the other hand, a bridging loan might help you snap up the perfect home without waiting for your existing home to be sold.

Bridging finance can help you ‘bridge’ the ‘financial gap’ between buying a new home and selling your existing one. However, it’s worth understanding the pros and cons of a bridging loan to ascertain whether it’s the right choice for you or not.

The pros of bridging finance

A bridging loan can offer some potential benefits to homeowners caught between selling their existing home and buying a new one.

• Purchase flexibility

One of the biggest advantages of a bridging loan is that it lets you buy your new home without waiting to finalise the sale of your current one. For instance, it may happen that you like a property so much that you want to buy it instantly. However, you may find it challenging to make a downpayment on the new house until your existing house is sold. One option you have is applying for a bridging home loan to finance the new property and get some more time to sell your existing home, which could help you fetch a better price by giving you the time to negotiate more favourable terms.

• Save on potential rental costs

By ‘bridging’ the gap between selling and owning your old and new homes, respectively, bridging finance may also help you save on any temporary storage or rental costs, as your new home will most likely be ready to move into by the time your old one is sold.

• Interest only payments

Some bridging loans offer interest-only payments during the loan term, which could help manage cash flow while you’re waiting for your current property to sell.

Cons of bridging finance

While a bridging loan could be a helpful way to finance your new home when you still haven’t sold your existing one, there are a few pitfalls you need to be aware of:

• Interest charges

The interest rate charged on a bridging loan is usually higher than the average ongoing home loan rate. Therefore, the longer it takes to sell your house, the more interest you will pay. If you opted to capitalise the interest, you’ll be paying interest on interest, which could add to your costs significantly.

• The risk of overborrowing

When you take out a bridging loan to purchase a property before your existing one is sold, there’s always the risk of stretching yourself too thin if your home sells for less than you expected. This could leave you with a larger borrowing and increased monthly repayments that may result in financial stress.

• Potential refinancing costs and fees

It’s also possible that your current mortgage lender doesn’t offer a bridging loan. In such a situation, you may have to refinance your existing loan, which will add to your costs. For example, you might have to pay exit fees to your current lender (if you have a fixed rate home loan) and valuation fees for both the properties.

• Strict eligibility criteria​​

Bridging loan eligibility requirements are generally more stringent than those for a standard home loan. Lenders typically look for:

• A sound financial profile, including a high credit score and a stable income.
• A significant amount of equity in your current property.
• A clear plan for repaying the bridging loan, usually through the sale of your existing home.

It’s worth remembering that not everybody qualifies for a bridging loan. Most lenders insist on substantial home equity to minimise their risk. Speaking with a mortgage broker can help you navigate these requirements and gain a better understanding of the pros and cons of taking out a bridging loan. This can help you determine whether a bridging loan aligns with your financial needs and goals.

When you apply for a bridging loan, lenders will calculate what is known as your peak debt. It is the sum of your outstanding mortgage and the value of the new property you intend to buy. So, if you have $300,000 outstanding on your mortgage and the new home you are buying is worth $600,000, your peak debt would be $900,000.

Most lenders will allow you to borrow up to 80 per cent of the peak debt. The remaining 20 per cent must be held by you in genuine savings. However, some lenders may not ask for a cash deposit if you have substantial equity in your existing home.

Once the property is sold, the amount is applied towards discharging your existing mortgage. The remaining amount is known as the end debt, which is converted into a standard home loan secured on your new property.

Types of Bridging Loans: Open vs. Closed

You can typically find two types of bridging loans on the market.

Open bridging loan

An open bridging loan generally does not have a fixed settlement term, with the loan duration typically ranging from 6 to 12 months. This type of loan might be suitable for those who have found a new property to purchase but are still seeking a buyer for their current home.

Since open bridging loans carry more uncertainty, the eligibility criteria tend to be stricter. Lenders may request detailed information about the new property and verify that the existing property is actively on the market for sale.

Closed bridging loans

A closed bridging loan is usually based on a pre-agreed date by which your existing property will be sold so you can pay out the remaining balance of the bridging loan. This may be suitable for borrowers who have already exchanged sale contracts on their existing property but need financing to buy the new house in the meantime.

When exploring alternatives to bridging loans, it's essential to carefully weigh your options to ensure you're making the most informed financial decision. One straightforward option could be to take out a second home loan, but this requires confidence in managing repayments on two properties simultaneously.

If you're hesitant to take on another mortgage right away, you might consider negotiating a longer settlement period for the new home, giving you extra time to sell your existing property before fully committing to the purchase.

In some situations, it may be possible to include a "subject to sale" clause in the purchase agreement for the new property, meaning the sale only becomes unconditional once your current home is sold. However, it's advisable to consult with an expert before using this option.

As always, there's no one-size-fits-all solution or financial product. If you prefer a more conservative approach, selling your current home first, even if it means renting temporarily, might be the best choice. Conversely, if you're looking to buy before selling, it may help to understand how each option could impact your finances and long term goals. Consulting with a mortgage broker can help you decide on a suitable path forward based on your specific circumstances.