What Is the Definition of a Bridge Loan?
Bridge loans are meant to cover gaps in funding because they can help reduce the effects of timing issues. Therefore, bridge loans are valuable to businesses because timing is essential when it comes to financing.
For instance, a business owner may have long-term financing established for a business’ expansion goal. This funding will not start, however, until the spring of next year. But the business owner needs to start financing the project immediately.
This is where a bridge loan comes in handy. If a business owner decides to get a bridge loan, then he or she may take out a short-term loan that matures when the long-term funding start. This means that the business owner will have access to funds to begin his or her project while awaiting the more permanent funding to kick in. After this occurs, the business owner will pay off the bridge loan using the profits from the permanent financing.
Bridge loans tend to be short-term in nature and come due in about a year or less.
Naturally, there are many more scenarios where bridge financing is beneficial to a business. Bridge loans offer different types of terms, conditions, and other factors.
This article will review everything that a business owner needs to know about bridge loans to see if it is right for their company.
Bridge Loan Terms, Repayment, and Application Process
The terms of a bridge loan and its application process will vary according to the specific lender and the borrower themselves.
For instance, perhaps a real estate developer is hoping to purchase some land and build apartments on it to later sell. The developer wants to get a construction loan, but before that can materialize, he or she needs financing the cover the purchase of the land. Thus, the developer would be in a good position to get a bridge loan to cover the gap in time. For this, the developer would have to work with a lender that offers bridge loans for land.
There are also lenders who offer bridge loans to startup companies that need money before their next round of funding.
Every lender will have specific application requirements and terms for bridge loans.
In general, bridge loans come with high interest rates, short terms, and strict requirements related to collateral. The application process is similar to that of a personal loan or term loan. During the application process, a business owner will need to submit the following:
- Proof of down payment
- Credit score
- Financial capacity
- Past business experience
Finally, the manner in which a business owner repays the loan will depend on what they are using the loan for. Usually, bridge financing is structured so that it has a balloon payment at the conclusion of the term. That said, if a business owner is using this funding for real estate, then lender tend to structure it so that he or she can pay using the profits of the real estate transaction.
When Do Bridge Loans Work the Best?
Bridge loans can help a business when it requires short-term financing to kick off a project before the owner can get permanent financing. That said, there are two main situations in which bridge financing is the best option.
Real Estate Purchases
Bridge financing is very common in the real estate sector. Bridge loans are especially helpful to developers and homebuilders, thought there are many other real estate situations in which bridge loans are helpful.
Anytime a developer buys one piece of real estate while selling another, bridge financing can help the developer afford closing costs, as well as other expenses. Homeowners will typically use bridge loans when they want to buy a new home before their current house is sold.
Startups in Between Funding Milestones
When a startup makes use of venture capital, bridge financing can be extremely beneficial. Bridge loans allows startups to meet their financial needs between funding rounds.
For instance, perhaps a startup receives $1,000,000 during its first round of funding. But may the next round of funding will only occur if the business makes a profit. The owner of the startup realizes that they will need more funding to become profitable. In this case, bridge financing can offer the short-term funds the business needs to become profitable. Once the business reaches its next round of funding, it can get rid of the bridge loan.
The only exception to this is the fact that for some investors, bridge loans are a red flag. Bridge financing can also take the form of convertible debt, which means that the lender is paid in the stock equivalent of the debt.
There is no way to be sure that a bridge loan is right for one’s business. There are pros and cons, as with any kind of loan.
A bridge loan can be expensive, and because it is short-term, there is not much room for error.
The pressure of a bridge loan coming due can make some borrowers nervous. However, when there is a temporary cash flow issue, these loans are very useful. This means that if a business owner can afford to pay off the loan with new financing or a major sale, then it is a worthwhile option to consider.