One of the best real estate opportunities investors look for is distressed properties, a situation where homeowners are in financial distress and have to sell their property quickly.
These situations usually arise when the owner is behind on mortgage payments, taxes, or other bills, and the lender plans to foreclose on the property. To prevent this from happening, the owner will try to sell the property as quickly as possible at a reduced price – which provides an opportunity for investors.
However, not all investors have the liquidity to purchase a property outright, which is where distressed bridge loans come in. A distressed bridge loan is a type of short-term loan meant to finance the purchase of a distressed property.
If you are considering investing in distressed properties, you’ll want to understand how a distressed bridge loan works and how it can help on your next project.
Why Investors Acquire Distressed Properties
There are several reasons why investors purchase distressed properties. The first is that they can get the property for a reduced price. If the homeowner is in financial trouble, they will often have to sell the property quickly. To sell quickly, the property is usually listed for less than it’s worth.
As a result, the investor can buy the property at a discount and potentially flip it for a profit.
The second reason is that distressed properties are often in less-than-perfect condition because the owner couldn’t keep up with repairs. This means that not only can you potentially buy the property at a discount if the owner needs to sell quickly, but you can invest in renovations and repairs to boost its value even more.
By buying the property and investing in repairs and renovations, you could increase the value and flip it for a substantial profit.
What Is A Distressed Bridge Loan?
A distressed bridge loan is a short-term financing option for purchasing a distressed property. The loan is typically for a six-month to one-year period, however it can be even shorter.
Many investors choose to use distressed bridge loans because they are easier to qualify for than conventional loans and have a much quicker turnaround time. Lenders can approve and service bridge loans within the week, and sometimes within just a few days depending on the situation.
Because owners of distressed properties need to sell fast, distressed bridge loans are an excellent financing option for investors.
What Institutions Typically Offer Bridge Loans?
Some larger financial institutions, like banks, offer bridge loans. However, most lenders that provide bridge loans are private lenders. The reason for this is that banks are more risk-averse than private lenders.
Banks prefer to do due diligence before qualifying borrowers and originating the loan, instead of approving the loan within just a few days of receiving the borrower’s application like a private lender would.
Banks also tend to be warier of real estate investors and prefer to work with homebuyers instead. Additionally, many distressed properties are in disrepair. Few banks are willing to approve a loan on a house that is not in livable condition.
How Do Bridge Loans Work?
Investors use bridge loans when they need quick financing. When it comes to conventional loans, it can take weeks for the applicant to be approved. By the time the lender services the loan, it may have taken over a month.
If you’re trying to buy a distressed property, this isn’t going to work, as the owner will have likely found another buyer in the meantime. Distressed property owners aren’t going to wait around – they need to sell as quickly as possible.
Bridge loans aren’t just for distressed properties either. Many real estate investors use them for fix-and-flip properties because they are short-term investments. Additionally, some sellers have deed restrictions, meaning the buyer can’t flip the property for at least 30 days after the closing.
Whatever the case, a bridge loan can help you close on a property quickly so you can get started with your investment. They are known as “bridge” loans because they help to bridge the gap between when you need to buy a property and when you can get traditional financing.
Many investors will use a bridge loan to buy a property. Then once they receive their long-term conventional loan, they’ll use that money to pay off their bridge loan.
The Advantages Of Bridge Loans For Distressed Properties
Although we’ve mentioned why investors will often turn to bridge loans, especially when it comes to distressed properties, it’s worth going over the benefits in detail. The following are a few of the primary advantages of using a bridge loan to pay for a distressed property:
Shorter Terms
You’ll find that distressed bridge loans have one of the shortest loan terms available out of all the different types of loans. Shorter loans are hugely beneficial for investors of fix-and-flip properties.
If you’re purchasing a distressed property that you plan to flip for a profit (whether it needs repairs or not), the shorter the loan term, the better. A shorter loan term lets you pay the loan off faster. Loans with longer terms will require you to pay more on interest over the long run. If you take out a shorter-term loan that you can pay off after you flip the property, you’ll save money on interest.
Flexible Repayment Arrangements
Many bridge loans will offer flexible repayment plans. Some lenders may base your repayment schedule on your exit strategy. For instance, you might pay interest on the loan every month until your exit date (when you flip the property or your conventional financing goes through). Once the term is up, you would then pay the principal amount owed.
Other bridge loans may have a more conventional repayment period in which you pay a part of the principal and interest every month.
Quick And Easy Approval
As mentioned before, conventional loans take at least 30 days to approve and service. On the other hand, bridge loans can be approved and serviced in a matter of days due to how easy the application and screening process is.
No Need For Intensive Document Collection
One of the reasons why the approval process is so quick and easy is that bridge loan lenders rarely ask for a massive amount of financial documents. Conversely, conventional lenders (such as banks) will perform exhaustive due diligence before approving a loan.
As a result, you might have to track down or complete a significant amount of paperwork before even submitting a loan application. Although bridge loan lenders may ask for specific documents, they will rarely require you to provide as much paperwork as a conventional lender.
Provides Additional Funds For A Time-Sensitive Transition
One of the main advantages of a quick and easy approval process is that you can immediately secure the funds you need. For example, if you have a time-sensitive investment opportunity (which most distressed properties are), then you’ll want to get funding in place as quickly as possible. As such, a bridge loan is often the perfect solution.
Disadvantages
As a real estate investor, there are several reasons why a bridge loan might appeal to you, especially if you’re a fix-and-flip investor or eyeing a distressed property. However, just like every other financing option out there, bridge loans are not without their disadvantages. The following are a few drawbacks that you should be aware of:
Higher Interest Rates
You’ll find that the interest rates on bridge loans are higher than almost any other type of loan. It’s not uncommon for interest rates to reach as high as 20% or more. However, the higher interest rates are offset by the short term lengths, the ease of qualification, and the quick turnaround time.
Increased Risk And Debt
The flip side of borrowing such a substantial short-term loan is that if your investment strategy fails, you could find yourself in significant debt. If you decide to apply for a bridge loan, then you need to have an exit strategy, whether it’s a date by which you plan to flip the property or a date on which a safer, conventional loan will come through.
Even then, there is some risk involved since things don’t always go according to plan.
May Require Collateral
The amount of risk involved is a two-way street. Not only is the borrower taking a risk, but the lender is also taking a risk. To help offset the risk the lender is taking, they’ll typically require that you put up an asset as collateral. This asset may be the property you’re purchasing, or it may be an existing property you own.
Either way, if you default on the bridge loan, it’s likely you’ll lose the asset you put up as collateral.
Additional Fees And Transaction Costs
The fast turnaround time of bridge loans comes at a cost. The following are some of the fees and transaction costs you’ll be required to pay when taking out a bridge loan:
- Origination Fees: Origination fees cover the costs of underwriting and processing the loan. They are charged as a percentage of the loan amount. Because of the quick process, the origination fees on a bridge loan are much higher than a conventional loan. Lenders typically charge around 2 to 4% of the loan amount in origination fees.
- Deferred Origination Fees: A deferred origination fee is an origination fee that is not due until the loan is paid off. Deferring the fee allows you to finance the origination fee into the loan amount. However, it’s not an ideal situation because you’re essentially paying interest on the origination fee.
- Extension Fee: An extension fee is a fee charged by the lender if you need to extend the loan term. This fee is a percentage of the total loan amount (usually 1-2%). Bridge loan lenders can provide flexibility by extending the loan term if things aren’t quite going your way.
For example, if renovations are taking longer than expected. Still, they will charge you an extension fee for doing so.
Rigid Loan Provision
Although bridge loan lenders can provide borrowers with some flexibility in the terms and conditions of a bridge loan, once they are in writing, they are set. If you hit a snag and need to renegotiate the terms, you’ll likely have to pay a hefty fee. This rigid loan provision should come as no surprise, considering the high amount of risk the lender is taking.
How To Qualify For A Bridge Financing?
Once you’ve weighed the pros and cons of bridge financing, you’ll need to determine whether you’ll even qualify for the loan. Fortunately, one of the benefits of a bridge loan is that the application process is relatively quick and easy because, unlike conventional loans, there aren’t as many restrictions as far as qualifying goes.
Having a sound real estate investment plan for your project is the most important thing. With that in mind, there are still a few things that lenders will look for when considering your application:
- Debt-To-Income Ratio (DTI): Unlike other types of loans, the DTI is often more important than your credit score or history.
If your DTI is high, lenders may question your financial ability to take on more debt. They may worry about your ability to make payments should your investment not go to plan. That said, the lower your DTI is, the better when applying for a bridge loan.
- Credit Score: There’s no set credit score requirement for bridge loans, but that doesn’t mean it doesn’t matter. A good credit score will help reduce the perceived risk of your investment, especially for larger bridge loans. Not to mention that lenders will be more willing to provide favorable or flexible terms the better your credit is.
- Credit History: Like your credit score, your credit history won’t be a significant factor in determining whether or not you qualify for a bridge loan. If you have blemishes on your credit history from years ago, they won’t negatively affect your chances of securing a bridge loan.
However, you’ll want to ensure that your recent credit history is solid to help alleviate any doubts a lender might have.
20% Equity In Your Current Home: To help offset the risk lenders are taking on such a substantial short-term loan, they’ll require collateral in the form of equity. Before applying for a bridge loan, you should have at least 20% equity in your current home (or one of your other properties).
Seize Your Next Project With The Right Financing Option
Bridge loans are a great financing option for investors looking to seize on a new real estate opportunity quickly. They are fast and easy to apply for and can give borrowers the flexibility they need to get their projects off the ground.
If you’re looking to invest in distressed real estate, whether you plan to fix and flip it or turn it into a rental property, a distressed bridge loan may be the perfect financing solution.