What is... | December 8, 2011

What is a bridging loan?

When we think of loans, a mortgage or student loan paid off over several years may spring to mind. A bridging loan differs as it is for a short time only – to cover the period between buying one asset (such as a house) and selling another, to help finance the purchase.

The arrangement – also known as a bridge, caveat or swing loan – can be helpful in certain circumstances but, be warned, it can also be fraught with danger.
And thinking traps can muddy decision making.

Caveat borrower
For a homebuyer who has found their dream property but is waiting for the sale of a property they already own, a bridging loan can be a rational way of ensuring they do not lose out to a rival buyer. Or perhaps there is an administrative reason for a time difference between buying one property and selling another.
But the risks involved mean that bridging loans are typically more expensive than conventional loans to compensate the lender for the additional risk. One risk is that – for whatever reason – the sale of the original property can fall through, leaving the buyer with two homes and lots of debt. Another buyer may need to be found or the bridging loan extended. Although there will be variations between countries and individual loans, the Financial Times writes that, in the United Kingdom, the expense of bridging loans may involve entry and exit fees and high monthly interest rates.

Troubled waters
Arguably, the emotion that is often involved in buying or selling property can muddy decision making.
The endowment effect thinking trap – explained in this eZonomics video – tells how people tend to overvalue property and other assets they own. When it comes to buying and selling the investments, this perceived value can have big implications on the choices we make. Likewise, overconfidence is another trait that can be expensive for investors.
In the case of property, an owner may decide to go ahead with a purchase of their dream home before finding a buyer for their original property. The borrower might put too high a price on their original home or be overconfident of a sale within the agreed time.

Horses for courses
Given the higher risks and costs involved with a bridging loan, the key lesson for borrowers is to ensure the bridging loan is the right tool for them given their circumstances. The Financial Services Authority, the UK regulator, has warned specifically about using bridging loans as an “imaginative” solution to housing and mortgage problems. It said it was not always in the consumer’s best interest for them to take out a bridging loan simply because they were in “payment difficulties”. It was a warning against borrowers using a bridging loan simply because they do not qualify for a typical mortgage.

Cross with care
Borrowers should always think carefully about the risks they are taking when getting a mortgage, as the eZonomics tips for mortgagors sets out.
An important test is to ensure you can meet the interest payments on the amount borrowed. This is particularly true for bridging loans.

House buyingMortgageDebtOverconfidence

Phil Thornton
Phil Thornton

Lead consultant at Clariti Economics