A quick look into some of the key differences between commercial and residential bridging loans, and other variations of bridging finance.
Anyone exploring how to fund a property development or purchase will have come across various financing options, most likely including bridging loans. So, what is a bridging loan, how do they work, what types of bridging finance are available and how do you apply?
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What is a bridging loan?
A bridging loan explained simply is a short-term loan, usually 12 months or less, that individuals or businesses can take to alleviate temporary funding gaps between buying and selling property. They can be used for both commercial and residential properties, are fast to arrange and provide borrowers with an immediate cash injection. Amongst homeowners, bridging loans are used for a variety of reasons. Typical examples are securing a property purchase or building a new home before selling their current one, or paying the upfront costs of buying property at auction before arranging long-term funding.
For property developers bridging loans have become an essential part of the business. Uninhabitable properties with no kitchen or bathroom facilities are not eligible for traditional mortgages, but they can be financed with a bridging loan and then developed and sold. Likewise, a bridging loan can be used to fund substantial property renovations that can be completed in a short time, rather than applying for a full development finance package. Because of the speed bridging loans can be arranged, developers can act fast on advantageous market conditions, like a reduced price on land to promote a quick sale.
Generally bridging finance has a higher interest rate than traditional finance but this is outweighed by the benefit of having quick and convenient access to funding.
How does a bridging loan work?
So how does a bridging loan work? Bridging loans are secured, which means they must have assets secured against them, usually a property or properties. If the borrower is unable to repay the loan, they could potentially lose their assets – hence why bridging finance was considered ‘the loan of last resort.’ Nowadays though, bridging loans are used regularly by property entrepreneurs as a convenient tool to facilitate quick lending transactions.
Most bridging loans UK wide are limited to 75% loan to value, and the amount that can be borrowed depends on the value of the secured assets and borrower equity. But it’s a vast scale, going from around £50,000 to £10 million. Unlike a mortgage, bridging loans are not linked to income. Using a bridging loan for property development work means it can be repaid by selling the new development or refinancing through a traditional mortgage.
Since large sums of money are loaned relatively quickly, interest rates are usually higher than other funding. There are three ways for interest to be applied on bridging loans:
· Monthly – the borrower uses cash flow to pay interest charges each month.
· Rolled up – the interest is rolled up and paid at the end of the term, but it’s compounded, so the final sum is larger than if it had been paid monthly.
· Retained – the interest cost is borrowed upfront for an agreed period. It’s considered part of the capital sum, so is also subject to interest. Unused retained interest is returned to the borrower on repayment of the loan.
Anyone asking how does a bridging loan work will naturally follow with questions on our next topic, the different types of bridging loans.
Types of bridging loans
As with most finance options, there are different types of bridging loans, including closed-bridge loans, open-bridge loans, first-charge loans and second-charge loans.
· Closed-bridge loans are when borrowers have a set date for repaying the loan. This could be when a property sale has been agreed with a completion date fixed.
· Open-bridge loans are when the borrower sets out a proposed exit plan for repaying but a definitive date is not set. There will be, however, a cut-off point by when the loan must be repaid.
First and second-charge loans refer to which lender will recoup their debt first (by repossessing the assets secured against the loan) if the borrower defaults. Logically, first-charge loans are repaid first so lenders are more willing and flexible with loan arrangements where they are the first-charge. Likewise, the rates are usually lower than second-charge loans where lenders try to offset the perceived greater risk by increased interest charges. The first-charge lender normally has to consent for a second-charge loan to be taken out. For example, if a homeowner has a mortgage and then secures a bridging loan against the house, the mortgage would be the first-charge lender and the bridging finance second-charge. For lenders to consider the second-charge loan, borrowers would need to have a viable exit strategy.
Second-charge loans are a great way to conveniently access the equity in a property without fully replacing the first-charge loan, i.e. remortgaging. With the types of bridging loans explained, let’s look at how to secure bridging finance.
How to apply for a bridge loan?
The bridging loan finance market has grown rapidly over the past decade, with several lenders competing for their share. Many developers now use bridging loans regularly, so it’s essential to know how to apply for a bridge loan. There are a number of bridging loan requirements, but crucial to any application is providing concrete assurance that it can be paid back.
Prepare a careful presentation showing relevant experience, exact plans for the loan and how it will deliver a profitable outcome. Be realistic with building costs, timescales and selling prices – lenders know the industry, so fudging prices will only lose lender trust. A clear exit plan is essential so lenders know how they will be repaid, whether through selling or refinancing the development. If the loan doesn’t cover all costs, provide cash flow information to prove it’s possible to complete and deliver on the exit strategy.
Although bridging finance is more expensive, it allows developers to buy the right property, at the right time and right price, so ultimately offers good value. Typically, higher deposits and better LTV mean applications are more likely to be approved and with better terms. First-charge loans can often be secured with a 25% deposit, whilst second-charge loans might require 40% or more.
There are a lot of factors to consider, but talking to a broker who specialises in bridging finance can secure the best rates. To learn more read our Smart Guide to Bridging Loans and for anyone considering how to apply for a bridging loan, the best way forward is to talk to the Brickflow team.