Bridge financing is a form of lending most people do not know much about. The majority of us will go our entire lives without ever having a need for a bridge loan. That being the case, the finer details of bridge financing can be confusing. For example, why do bridge loans tend to be structured as interest only loans?
What is an interest only loan?
An interest only loan is a loan with monthly payments that cover only interest. The amount borrowed, a.k.a. the principal, is repaid in a lump sum on the loan’s maturity date. The advantage of this sort of setup is lower monthly payments. Because the borrower is only paying interest, he does not need as much cash to service the loan from month-to-month.
The obvious drawback is having to come up with the entire principal at maturity. That could be a sizable amount of money. If a borrower doesn’t have it, he either has to arrange a new financing package or risk losing his property.
What is a bridge loan?
A bridge loan is a type of loan that bridges the gap between immediate need and future funding source. Consider a Utah private lender known as Actium Partners. Actium might provide a bridge loan to a real estate investor looking at a 6–12-month delay for arranging conventional financing on a commercial property.
Actium’s bridge loan allows the investor to still obtain the property while buying him a full year to arrange a conventional loan with his bank. He does not risk losing out on the deal because his bank needs more time.
How does the interest only arrangement play into it?
Finally, we get to the question of why bridge loans tend to be structured as interest only loans. It is really a matter of the borrower being cash poor. A less-than-desirable cash position is just assumed when a buyer or investor seeks a bridge loan. The individual has the assets to cover the loan, but those assets are not liquid.
Structuring the loan as an interest only loan forces the borrower to still make monthly payments. Moreover, those payments go toward interest, thereby minimizing the lender’s risk. The borrower’s cash position is not jeopardized because the monthly payments are affordable.
Are interest only bridge loans risky?
Interest only bridge loans are risky propositions. The lender risks not being repaid on schedule. Meanwhile, the borrower risks losing assets in the event that his exit strategy fails. But the risk is worth taking for both parties.
Despite the risks, lenders appreciate bridge loans because they represent a good way to make significant profit in a short amount of time. For lenders, it is all about earning as much interest as possible regardless of the term. Bridge loans, being as short as they are, allow a lender to turn over the same money multiple times in just a few years. So the potential to earn a significant ROI is always there.
Borrowers are willing to take the risk because bridge longs are fast, simple, and flexible. They are willing to pay a little bit more with the knowledge that they can obtain more properties without having to tie up so much cash. Every property represents the opportunity to earn a higher return. So in the end, bridge loans more than pay for themselves.
Your typical bridge loan is structured as an interest only loan in order to keep the borrower’s cash position on solid ground. The arrangement works well for lenders and borrowers who know how to use the bridge loan properly.