What happens when you need to buy your next home but haven’t yet sold your existing one? You’ll need financing, generally in the shape of a second mortgage. Two types of those are strong contenders. But which is better for you? We’ll help you decide in our bridge loan vs HELOC article.
Oxford Dictionaries defines a bridge loan as “a sum of money lent by a bank [or other lender] to cover an interval between two transactions, typically the buying of one house and the selling of another.” In other words, you’re bridging the gap between your home sale and purchase.
Of course, most people wait to agree on a sale of their existing home before they commit to a purchase. But that’s not always possible.
Suppose your employer has transferred you across the country and you want your family to settle in quickly. Or imagine you’re trying to buy your new home in a sellers’ market, where homeowners receive so many sure offers that they won’t entertain one that’s contingent on the sale of an existing home.
In those and other circumstances, you may decide it’s well worth the expense to take out a bridge loan to achieve your goal.
Bridge loans are a type of second mortgage. That’s because you have to use your existing home as collateral. In other words, your lender can foreclose on that home if you default.
However, bridge loans are different from traditional mortgage loans in other ways. To start with, they’re bridging a short-term gap rather than providing a long-term way to buy a new property.
So, many bridge loans last just a few months: the time it takes you to sell. And they’re often capped at six months or a year.
What happens after that? You may need to apply to renew that loan or find a new one. Just bear in mind the closing costs you’ll have to pay in those circumstances.
HELOC is an acronym (pronounced Hee-Lock) and stands for home equity line of credit. Like a bridge loan, it’s a type of second mortgage. However, unlike a bridge loan, it’s an any-purpose loan.
That means you can use the money you borrow for anything. And, if that includes bridge, interim financing, that’s your business. Your HELOC will expire when you sell your existing home, and lenders can make losses on early redemptions of these lines of credit.
Being lines of credit, HELOCs are a bit like credit cards. You’re given a credit limit and can spend up to that. (However, unlike credit cards, your credit score won’t take a hit if you max out your line.) You can then repay and reborrow as often as you like. And you pay interest only on your current balance.
HELOCs don’t last forever. Most banks and lenders have repayment periods that vary between 10 to 20 years. So, your chances of having to refinance your bridging HELOC are remote.
Of course, you may well want to refinance your HELOC after your sale, especially if your new home needs work. These can be excellent — sometimes tax-efficient — ways to pay for renovations and remodelings. You might also use one to consolidate your current borrowing, which could earn you a lower mortgage rate on your new house.
Yes, a bridge loan and HELOC can be used in the same way. But they don’t have to be.
A bridge loan must be used to provide a money bridge that covers the interval between your home purchase and sale. You can use the proceeds of a HELOC for anything you choose.
Once you receive your HELOC funds, your lender isn’t interested in what you do with the money. You can use it as a bridge loan, for home renovations, as seed capital for a new venture, to consolidate your debts, for a big wedding, or to fund a wild weekend in Vegas.
So, there is no apparent bridge loan vs HELOC winner unless you have other plans.
Chances are, you don’t yet know whether a bridge loan or HELOC will suit your personal finances better. If there’s a serious chance your bridging requirement will last more than a year, you might be leaning toward a HELOC.
That’s because a typical HELOC lasts ten times as long as a bridge loan. So, you could avoid the expense of refinancing a bridge loan at the end of its maximum 12-month term.
Second mortgages require you to have enough equity in the home and use your residence as collateral. And you can’t use the same money to secure a loan twice.
So, any borrowing for a bridge loan or HELOC will be based on the amount of “equity” you have in your current home. That’s the current market value of the home minus the amount you owe on your mortgage — or mortgages if you already have a second mortgage.
Let’s look at an example. Suppose your home has a current market value of $500,000. And your home loan balance this morning was $300,000. Your equity would be $200,000. That’s $500,000 home value – $300,000 balance = $200,000 equity.
But you can’t usually borrow 100% of your equity. Most bridge loan lenders want you to borrow no more than 80% of it while most HELOC lenders let you borrow 85%. So, using our example, you could typically borrow $160,000 for a bridge loan or $170,000 for a HELOC.
These percentages are called your loan-to-value ratios (LTVs). Of course, if you shop around several mortgage lenders, you may find ones that allow smaller or bigger LTVs. Some (likely a few) lenders of “high-LTV HELOCs” permit 100% LTVs. If your finances are tight, this could be a bridge loan vs HELOC knock-out punch.
In our bridge loan vs HELOC comparison, do the different forms of borrowing have various tax implications? Well, we’re not tax experts, but Intuit’s TurboTax website suggests not:
“You get a tax deduction for interest paid on your mortgage, but what about the bridge loan and the loan on the new residence that you buy while waiting for the old residence to sell? Good news. Interest on loans for the purchase or improvement of up to two residences is tax deductible, so it is likely that you can deduct the interest on both mortgages and the bridge loan. And property taxes are tax deductible on all properties that you own as well.”
Elsewhere on its site, turbotax says: “As long as the HELOC is used to purchase the home, the interest will be fully deductible.”
Of course, you can only deduct these costs if you itemize your deductions rather than take the standard one. And, again, there’s no bridge loan vs HELOC winner here.
Besides those considerations, your choice will likely be based wholly on the cost of borrowing for each. And we’ll be covering that next.
This is being written at a time when rates for mortgages and second mortgages are changing very quickly. And, as always, there are wide variations between the deals offered by different lenders.
So, our advice is to shop around a range of lenders to see whether you can get a better deal on a bridge loan or HELOC. Remember, this is a frog-and-princess process: the more lenders you “kiss,” the more likely you are to find your princely or princessly lender.
And don’t forget to look at your total cost of borrowing rather than just the interest rate. Fees and closing costs can make a big difference to the amount you pay overall.
Chances are, you’ll find a HELOC more attractive financially. Typically, they have lower interest rates and you may be able to find a no-closing-costs deal. But keep an eye out for fees for early redemptions and ongoing usage. Focus on the big picture: the dollars and cents each loan will cost you in the end.
Don’t like the sound of either a bridge loan or a HELOC? Unfortunately, your choices are limited:
There’s a reason we’re focusing on bridge loan vs HELOC here.
There are several ways in which the contenders are equal in our bridge loan vs. HELOC comparison. They’re both second mortgages. They can both provide short-term financing options. Intuit TurboTax reckons they can deliver similar tax benefits. And they’re almost always better than their alternatives (except the rich relation or friend one).
However, there are important differences, too. And we suspect that most readers will find HELOCs more appealing. They tend, on average, to have lower interest rates and loan costs than bridge loans. And they’re more flexible over the repayment period, terms, and your use of the proceeds.
Still, we can’t guarantee that will be the case for every reader. So, you may wish to get quotes from multiple lenders across both types of loans to find yourself the best possible deal. Check current HELOC rates now.
But before you decide on any form of bridge financing, consider how it could affect your long-term financial goals, especially if it takes longer to sell your existing home than you expect. It’d be a wise idea to consult a financial advisor before committing to either loan.
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