What is a Bridge Loan?
Bridge loans, also known as swing loans or bridge financing, are a short-term financing option for companies that need funds temporarily until long-term financing becomes available. Essentially, they “bridge” the gap between a company’s immediate need for funds and access to funds from long-term financing.
What are bridge loans used for?
Bridge loans are used for a range of purposes, from meeting working capital requirements to covering floatation costs for an upcoming initial public offering (IPO).
However, the most common use case is for urgently purchasing commercially attractive real estate. It may take a company days or weeks to arrange for long-term financing. A bridge loan provides funds immediately, enabling the company to leverage the opportunity and then continue to arrange for long-term financing.
How does a bridge loan work?
Bridge loan terms and conditions differ among lenders. They do have some common features, though. Most bridge loans have a 6 to 12-month term and a loan-to-value ratio (LTV) of up to 80% of the property’s value.
Lenders tend to charge a higher-than-usual rate of interest on bridge loans because they’re perceived as riskier. The interest rate generally varies between the prime rate and 12%, but the exact rate depends on a range of factors, including the borrower’s current debt obligations and creditworthiness.
They also charge an origination fee and a closing fee. Before signing the loan agreement, borrowers should ask the lender about potential fees that could increase the borrowing cost. Some common fees include:
- Administration fee
- Origination fee
- Notary fee
- Appraisal fee
- Title policy fee
Here’s an example of how a bridge loan transaction for financing commercial real estate would generally go:
Assume that a borrower is interested in a property valued at $200,000. With an LTV ratio of 80%, the borrower can borrow a maximum of $160,000. The remaining $40,000 must come from the borrower. When the borrower finds a long-term source of financing the purchase, they can use the proceeds to pay off the bridge loan.
Bridge loan use cases
While commercial bridge loans are most commonly used for financing the purchase of commercial real estate, they’re also used for several other purposes.
- Stocking opportunities: Assume that one of a company’s suppliers is winding up its business and wants to sell all of its inventory at a deep discount. The company may not have enough working capital to make this purchase, but a bridge loan can finance this transaction.
- Partner Buy-Out: A partner at a firm has decided to exit. The other partners want to buy them out but lack the capital. The remaining partners can use a bridge loan to obtain funds for the buy-out and gain some time to arrange for long-term financing.
- Buying equipment: Imagine a company received a big-ticket contract from a large corporation and requires an immediate equipment upgrade. A bridge loan can give the company access to quick cash needed for the equipment, and the company can then arrange for long-term financing.
What do lenders look for before approving a bridge loan?
All lenders have different eligibility and approval criteria. In general, they look at the following four factors.
Debt service coverage ratio (DSCR)
The lender will want to ensure that the property (or another asset) the borrower is investing the funds in will generate enough operating income to cover the bridge loan’s carrying cost, plus a safety margin. Ideally, a DSCR of 1.1 and above will make the lender feel comfortable and improve the borrower’s chances of approval.
Collective net worth
Lenders require all principal applicants to submit their financial statements. The lender uses them to assess the collective net worth of the principals and also to determine the business’s financial health. Lenders typically limit the loan amount to the collective net worth of all applicants.
The principals will need demonstrable experience with similar projects that they’re proposing to undertake with the borrowed funds. The borrower’s experience with similar projects influences key terms of a bridge loan such as the origination fee, interest rate, and approved amount. If a borrower has no prior experience, most lenders will not approve a bridge loan.
Credit scores are a critical factor for most types of loans, but they’re relatively less important for commercial bridge loans. Lenders will still want to confirm that borrowers have a score of 650 or more. However, this is mostly to ensure the borrower’s capability to secure long-term financing for paying off the bridge loan when it becomes due.
Types of lenders that offer commercial bridge loans
Borrowers should approach multiple lenders for a commercial bridge loan to see which one offers the best terms.
The following are the types of lenders borrowers could approach:
- Banks and credit unions — The first lender borrowers should approach is a bank or credit union they already have a working relationship with, provided it offers bridge loans.
- Private investors — If banks are reluctant to lend a borrower money because of poor credit history, they may apply for a bridge loan with a private investor. They tend to focus more on the property’s value than the borrower’s credit score and other factors, but they’ll charge a higher interest rate.
- Non-qualified mortgage lenders (Non-QM lenders) — Some non-QM lenders, also known as alternative lenders, specialize in short-term financing products like bridge loans. They could even offer more favorable terms like interest-only payments during the term and a final balloon payment.
Bridge loans can help companies take advantage of an opportunity just as it presents itself. Be forewarned, though. They can be risky and expensive. If the investment strategy backfires or if the borrower fails to obtain long-term financing, the high-interest rate debt can lead to financial distress or even default.
That said, bridge loans have been used successfully and profitably by many. They offer quick access to cash that provides an adequate buffer to arrange for long-term financing. The additional time bridge loans provide to secure long-term financing is valuable for both small businesses and large corporations. Companies should weigh the risks and benefits to see if a bridge loan is the best choice for the business’s needs.