What is a 'bridging loan'?

When to use bridging finance

Investors relying on funds from a property sale for their next purchase often struggle with the timing of settlement dates, director of Rhino Money Mark O’Donnell says.

“The property you buy may settle before the one you sell, so there may be a point where you have a higher debt. You may need funds to bridge that situation,” he explains.

Similarly, these loans can be a last minute solution when finance approval is delayed or rejected after the contract has been signed.

Reapplying with a new lender may take several weeks, Aussie Newtown principal Matthew Rogers explains. In these circumstances, short-term loans can be approved within 48 hours to cover the time between settlement and loan approval.

In other situations, investors who find a bargain may sign a contract before finance has been approved and then rely on short-term finance to overcome any immediate issues.

While this approach may pay off in extraordinary cases, Mr O’Donnell encourages caution.

“If you do have an opportunity of a lifetime, it may be worth it as long as you weigh up the ins and outs and have a fairly reasonable end date,” he says.

Meanwhile, director of Shape Home Loans Michael Chan frequently sees investors use bridging loans to finance construction.

“You get a lot of people who take 12 months to build a property but want to live in their current property and not rent,” he says.

In these cases, investors don’t have the immediate capital to fund their investment construction projects because they are not selling their existing house.

The bridging loan can thus fund the construction until they sell the newly constructed investment property or are able to lease it out.

The property you buy may settle before the one you sell, so you may have a higher debt. You may need funds to bridge that situation.

Advantages for investors

Bridging loans allow settlement to be completed even when traditional finance has fallen through.

Missing settlement can be costly for the buyer. Each day of delay incurs penalty interest, Mr Rogers says.

This interest is generally calculated at 10 per cent of the purchase price per year on a pro rata basis. For example, on a $600,000 purchase, the buyer would pay approximately $165 per day.

Mr Rogers encourages investors to do a cost analysis if settlement is unlikely to proceed.

“A week’s penalty interest, while you’d rather not pay it, probably isn’t going to be that bad. You’d cop it. The cost of the short-term finance in fees alone would be more,” he explains.

However, if settlement is delayed for longer, short-term finance may be the more affordable option, he suggests.

In addition, investors risk losing their deposit if the vendor issues a Notice to Complete.

“They basically say ‘You have two weeks to complete settlement and if you do not, you’re in breach of contract and lose your 10 per cent deposit’,” Mr Rogers says.

If a deposit is $40,000 and short-term finance costs $10,000, an investor would “be silly” not to take advantage of the loan, according to Mr O’Donnell.

Short-term lenders’ approach to assessing serviceability on the loan can also be advantageous for investors.

Lenders assess the buyer’s ability to service the loan on the “end debt” – the loan amount left over after the original property has been sold.

This means an investor may be approved to carry a loan amount equivalent to two mortgages, even where their income could only service one, Mr Chan says.

In Mr O’Donnell’s experience, the exit strategy from the bridging loan is the most important factor in serviceability.

“As long as your exit covers the debt you’ve got to repay, plus the interest, then it’s usually acceptable,” he says.

Investors could also benefit from the practice of capitalising interest on bridging loans.

Most lenders will allow the interest charged on the new loan to be added to the total sum borrowed. This is bundled together and investors can pay the interest off when their original property is sold.

“If it takes you 12 months to sell your current property, you would have paid X amount of interest. Instead of paying that money out of your own pocket, you can actually borrow that sum so it gets added to the loan,” Mr Chan says.

This is particularly appealing for investors with low cash assets, or those who want to reserve funds for other projects, he says.

“The ability to capitalise interest is important, or people might not be able to afford it monthly,” Mr O’Donnell explains.

Drawbacks for investors

While helpful in a pinch, bridging finance comes at a steep price.

Buyers could pay up to three times more in interest and fees than a normal mortgage, Mr O’Donnell says.

Although interest can be capitalised, it accrues at a rate of one to three per cent a month.

Moreover, the interest is calculated on peak debt, meaning the existing loan plus the new mortgage and associated costs.

Fees also tend to be higher, Mr O’Donnell says.

While these outlays may seem excessive, he believes bridging loans are not really comparable to long-term loans because they are designed to end quickly.

The high fees are necessary to protect the lender from risk, he says.

“The issue is the loans are generally short-term lends and they’re high risk so the funders generally don’t make a lot of money out of them. They need to be done at higher rates to cover the cost,” he says.

If the costs do not deter investors, the loan requirements might. Investors hoping to purchase property with a high loan-to-value ratio (LVR) may struggle to secure this type of finance.

“With bridging loans, you can only go to a maximum of 80 per cent LVR and a lot of lenders are now pushing that down to 70 per cent,” Mr Chan says.

Loans with an LVR higher than 80 per cent also attract mortgage insurance, an expense that can become prohibitive, Mr Rogers says.

“If they can borrow 85 per cent for instance, it can be quite a lot because they work out mortgage insurance on the peak debt. If you’re below 80 per cent, great,” he says.

A further disadvantage is that investors may have to sell at an unfavourable price to bring a quick end to the loan term.

“You want to be sure you will be able to sell your property reasonably quickly and get the price you want. You don’t want to be forced to sell in six months time and take a lower price,” Mr Rogers says.

Some bridging loans have expiry dates. When this cut-off is reached, the lender can force the sale of the property regardless of market conditions, Mr Chan says.

Yet bridging loans without expiry may cause just as much damage to the investor’s bottom line if the property fails to sell.

Moreover, investors should be wary of unscrupulous dealers operating in the short-term finance space, with high rates aimed at people in desperate circumstances.

“If you’re paying more than one to three per cent, you probably should be talking to someone else,” Mr O’Donnell says.

Top tips for bridging loans

Investors are generally advised not to ‘rely’ on bridging finance as a means of building their portfolio.

Instead, investors would be well placed trying to ensure their finances are stable and secure – thus avoiding the need for short-term solutions.

Mr Chan believes this type of loan is poorly suited to investors, many of whom depend on high LVRs and favourable market conditions.

Arranging pre-approvals and engaging a mortgage broker early in the process can help minimise the need for last minute finance, Mr Rogers advises.

“This is where your due diligence is so important,” he says.

Negotiation with the vendors may also help to avoid penalty interest or forfeiture of the deposit.

“The vendor may be willing to just have the settlement run a bit late and reduce the penalty charges they give you. Or, just from the outset, if you think you’re going to need more time, try to negotiate a longer settlement period,” Mr Rogers suggests.

However, Mr O’Donnell warns if the vendor’s sale is also chained to a future property purchase, an extension may be unlikely.

If a bridging loan is the best available option, Mr Rogers advises investors to have a firm exit plan.

“Especially in short-term finance, you’d want to have another mainstream lender lined up ready to take on the security and the debt and pay out the short-term finance,” he says.

Bridging finance is a risky strategy to prevent the sale of a house falling through. Investors must weigh the expense of the loan against the opportunity cost of losing the property or deposit, Mr Rogers explains.

“Some short-term finance can be quite costly,” he says, “so try to make sure the cost is worth the reward.”

Standard home loan versus bridging loan

Source: Mark O’Donnell, Rhino Money; Matthew Rogers, Aussie; Michael Chan, Shape Home Loans

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