Bridge loans are becoming increasingly popular in the UK, with many homeowners using them to purchase a new home while they wait for their current home to sell – but how does a bridge loan work?
What exactly is a bridge loan?
A bridge loan is a form of short-term finance that can be used to help you make a purchase or investment while you’re waiting for personal funds to become available. It does this by ‘bridging the gap’ between the amount of money you currently have available and the total amount that is required to make the purchase.
Bridge loan agreements usually involve borrowing relatively large sums of money for short periods of time. They generally have high interest rates and are backed by some form of collateral in most cases, such as your home or other properties you own.
In the first quarter of 2023, a record-breaking £278.8 million in bridging loans was lent, proving it to be an incredibly popular finance option.
Most people use bridging finance to purchase a new home when their current home has not been sold yet.
How does a bridge loan work?
There are two types of bridging loans: open bridging loans and closed bridging loans. Each loan works slightly differently, so it’s important that you understand the difference.
Open bridging loans
Open bridging loans do not have a fixed repayment date, which means they can be paid whenever your funds become available.
However, the lender will typically expect you to pay back the full amount within one year. Some lenders may offer longer repayment terms, but this is not common.
Closed bridging loans
Closed bridging loans have a fixed repayment date that is agreed in advance by both parties. The date is typically set based on when you know you will have your funds available, for example the completion date of a property purchase.
This type of bridging loan is usually cheaper than an open bridging loan because it offers less flexibility when it comes to repayment.
No matter which type of bridging loan you choose, it’s important that you have a strategy to repay your loan to avoid damaging your credit score. Most lenders will want to know exactly how you plan to repay your bridge loan, for example through the release of home equity or through mortgage payments.
What are ‘first charge’ and ‘second charge’ bridge loans?
Knowing what is meant by ‘first charge’ and ‘second charge’ is also important when it comes to understanding how a bridge loan works.
When you take out a bridge loan, a ‘charge’ will be placed on your property by the bridging lender. This means that if you fail to repay the loan on time, they will take their repayments from the sale of the property.
‘First charge’ bridging loans are placed on properties that don’t already have any other loans secured on them (properties that are owned outright, for example). If you failed to repay the loan and your home was sold to pay off the debt, the bridge loan lender would receive their repayment first.
‘Second charge’ bridging loans are for properties that already have one or more other loans secured on them (such as a mortgage). If you failed to repay the loan and your home was sold to pay off the debt, the bridging loan lender would take their repayment second – after your mortgage provider had taken theirs.
Second charge loans are usually more expensive than first charge loans because there is a greater chance that the second charge lender won’t recover their money if you fail to keep up with repayments.
What alternatives are there to a bridge loan?
A bridge loan is designed to be a short-term solution while you wait for personal funds to become available, but it isn’t your only option.
There are several other finance solutions that you could consider:
- Remortgage: Remortgaging your current home can help to free up money. However, you need to think carefully before remortgaging – it’s a long-term decision and you need to be certain that you’ll be able to keep up with your payments even if the interest rates change or your income falls unexpectedly.
- Let-to-buy: This involves switching your existing mortgage to a buy-to-let mortgage and using any equity released to purchase a new home. Rather than selling your old home, you rent it out. There are several risks that you need to consider though, such as whether you’ll be able to afford two mortgages and what you would do if you struggled to find tenants.
- Personal loan: If you only need a relatively small bridge loan (less than £25,000), a personal loan could be a good alternative. Interest is charged annually rather than monthly on a personal loan, so the repayments are likely to be cheaper. This type of loan is not secured against your property either, so you won’t be at risk of losing your home.
- Secured loan: A secured loan lets you borrow a larger amount of money than a personal loan, and will usually charge lower interest rates than a bridge loan. However, as with a bridge loan, you could lose your home if you fail to keep up with repayments.
If in doubt about any of these finance options, it’s best to seek advice from a professional to ensure you make a decision that’s right for you.
For more information on all things loans, explore Finance Rate’s comprehensive loans guide to find reliable answers to all of your questions.