What is a Bridge Loan?
Bridge Loans represent a source of short-term financing until the borrower – either a person or corporation – secures long-term financing or removes the credit facility altogether.
Table of Contents
- How Does a Bridge Loan Work (Step-by-Step)
- Bridge Loan in Real Estate Financing: Mortgage Example
- Pros of Bridge Loans: Speed, Flexibility and Closure
- Cons of Bridge Loans: Interest Rates, Risks and Fees
- Bridge Loans in M&A: Investment Bank Short-Term Financing
- Loan Interest Rate Pricing: Default Risk Considerations
How Does a Bridge Loan Work (Step-by-Step)
Bridge loans, or “swing loans,” function as short-term, temporary financing provided with the intention to last around six months and up to one year.
Short-term bridge financing loans are most common in the following areas:
- Real Estate Transactions: Finance the purchase of a new home prior to selling the current residence.
- Corporate Finance: Fund M&A deals where more financing commitments are needed for the deal to close.
In either scenario, the bridge loan is designed to provide near-term funding during a transitionary period.
The bridge loan closes the gap between the date of the new purchase (i.e. transaction close) and the date when permanent financing has been found.
Bridge Loan in Real Estate Financing: Mortgage Example
Under the context of real estate, bridge loans are utilized when the buyer has insufficient funds to purchase the new property without first selling the property still in their possession – i.e. that is currently on the market.
Typically, these types of short-term instruments are characterized by the following characteristics:
- Secured with Current Home Pledged as Collateral
- 6-Month to 1-Year Lending Term
- Same Lender is Often Financing New Mortgage
- Borrowing Ceiling of ~80% of Original Home’s Value
In effect, the temporary financing commitment offers homebuyers the opportunity to purchase a new house prior to actually selling their current home.
Pros of Bridge Loans: Speed, Flexibility and Closure
- Quick, Convenient Source of Financing
- Increased Flexibility (i.e. Bypass Hurdles with Further Delays)
- Removed Contingencies and Doubt from Other Parties (e.g. Seller)
- Could Directly Result in a Successful Deal
Cons of Bridge Loans: Interest Rates, Risks and Fees
- Expensive Fees (i.e. Upfront Charges, Higher Interest Rates)
- Risk of Losing Collateral
- Origination Fees (i.e. “Commitment Fees”)
- Short-Term Financing with Penalties (e.g. Funding Fees and Drawn Fees to Incentivize Repayment)
- Approval Required Strong Credit History and Stable Financial Performance
Bridge Loans in M&A: Investment Bank Short-Term Financing
In M&A, bridge loans function as an interim financing option used by companies to reach their required total financing needs with a short-term loan.
Similar to their role in real estate financing, these short-term facilities are arranged with the intention of long-term financing from the capital markets to replace it (i.e. “taken out”).
Most often, the provider of the loan comes from an investment bank, or a bulge bracket bank; to be more specific, i.e. the bank has a “balance sheet” rather than purely offering M&A services to its clients.
In the event of a time-sensitive transaction where financing is needed promptly or else the deal might collapse, the investment bank can step in and provide the financing solution to ensure the deal closes (i.e. reduce the uncertainty).
Otherwise, the funding – which can come in the form of debt or equity – is contributed by a venture capital (VC) firm or a specialty lender.
Loan Interest Rate Pricing: Default Risk Considerations
But generally, the interest rates are higher than typical rates under ordinary circumstances – in addition, lenders often place provisions where the interest rate increases periodically across the term of the loan.
Sellers in M&A deals can require the buyer’s financing commitments to be fully secured as a condition to proceed further in the process, so buyers often turn to investment banks for support in obtaining financing commitments.
However, it is very important to note that bridge loans in M&A are NOT meant to be a long-term source of capital.
In fact, corporate banks aim to avoid bridge loans that remain outstanding for too long, which is why conditional provisions are included to push the client to replace such facilities as soon as possible.