Before embarking down the world of bridging loans, let us give thanks that we are not navigating the murky waters of the UK property market.
Ever talked to anyone trying to buy a home in London who is stuck in what they call a “property chain”? This is where a chain of buyers and sellers (imagine 12 individual couples) are linked to one another by the homes they are both buying and wanting to sell, where the progress of their home purchase can only go as far as the slowest link in their chain. Imagine if the person who you are buying a home from is waiting on the person that THEY are buying a home from, who is, in turn, waiting to sell THEIR home but can’t do so because the next person in the line hasn’t picked up their phone for a week… well, you get the idea. Things can get backed up.
Luckily we do not have this problem in Australia, thanks in part to mechanisms like bridging loans. What is a bridging loan? It is simply a loan that you can take out while you look to sell your existing home. It means that you do not have to sell your existing home before you buy your next home. This eliminates the dependence buyers and sellers may have on one another for the success of their own deals.
Another way to think of a bridging loan is as an interest-only loan that exists in that period between selling your home and buying a new home. Once you have done this, a bridging loan converts into your new home loan.
Note: many of the upfront costs of buying a home, (i.e. stamp duty) can be loaded onto your bridging loan.
How does a bridging loan work?
There are two types of bridging loans to consider when looking to sell your home and buy a new home: closed and open bridging loans.
Closed bridging loans are those that are offered by lenders to a borrower who can provide a set date by which their own existing property will be sold. This is ideally suited for those who have already agreed on the sale terms of their existing home with a buyer. These are a low-risk loan for lenders, as the lender has a greater sense of security that you will be able to sell your home. As such, these often offer lower interest rates.
Open bridging loans occur when you have yet to establish the terms of the sale of your existing home or if you haven’t even put your home on the market yet. You may want to do this if you have discovered a home you want to buy before selling your existing home. These are a higher risk loan for lenders, so often come with higher interest rates, a greater burden of proof in terms of proving your ability to sustain costs, and the need for larger equity in your existing home.
Which home loan is right for you?
When comparing home loans, it is important to know what equity you can offer your lender. Bridging loans often require more equity in your home so that you can provide a larger deposit on the new purchase and have a smaller Loan-to-Value-Ratio. The interest on a bridging loan is compounded month on month, which incentivises you to sell your home as soon as possible.
Finally, when comparing home loans, knowing what equity you have in your existing home will help you choose a bridging loan, as some lenders will not increase the interest rate on your bridging loan if you lack significant equity in your existing home.
How is a bridging loan calculated?
Very simply! A lender will calculate your peak debt. From this they will calculate your ongoing balance.
The formula for calculating your ongoing balance:
If you owe $100,000 on your existing home loan, the lender will add this to the cost of your new home (let’s say $600,000). So your peak debt will be $700,000.
They will then subtract the value of your existing home (let’s say $400,000) from this peak debt.
So your ongoing balance will be $700,000 – $400,000 = $300,000.
Should you take out a bridging loan?
Bridging loans may require you to satisfy certain criteria, as are mentioned above. For instance, you may need to have existing equity and be able to provide a certain deposit (i.e 20 per cent). You may also need to sell your home by a certain period (i.e. 6 months) before your interest rates are increased.
Bridging loans are beneficial for those who don’t want to rent while they look for their new home or who have already found their next home and are yet to sell their existing property. Bridging loans are given their name because they help smooth the transition between selling your home and buying a new home.
The downsides of a bridging loan have been mentioned. These include the risk of having a higher interest rate if you do not sell your home within a set period for a closed bridging loan agreement, while you may have the added costs of valuing both your existing home and your new home to ascertain the ongoing balance of your bridging loan. As has been mentioned, this cost can be mitigated by the fact that you can sometimes add the upfront costs of buying a home to your bridging loan.
Buying a home? Get a bird’s eye view and compare home loans here.