Many homeowners who are moving rely on money they’ll get from the sale of their current home to fund the purchase of a new one. But closing dates don’t always align, and when that happens, you can find yourself in a precarious financial balancing act. A bridge loan can help provide funding for the purchase of a new home if you were relying on the funds from sale of your existing home to purchase the new one. But there are drawbacks to this kind of short-term borrowing aimed at bridging a financial gap. A bridge loan is a type of short-term loan that may be used in real estate transactions when the buyer lacks the funds to finance the purchase of the new property without the prior sale of the first property. A bridge loan is temporary financing to provide a way figuratively, a ‘bridge’ — to purchase an additional home without first selling a home.” The maximum amount you can borrow with a bridge loan is usually 80% of the combined value of your current home and the home you want to buy, though each lender may have a different standard. For example, if your current home is worth $250,000 and the home you want to buy is worth $330,000, your maximum bridge loan amount would be calculated this way: ($250,000 + $330,000) x .80 = $464,000.
A bridge loan in real estate can be used to buy another home before you sell your current one. A bridge loan essentially helps fund your new home purchase. For example, you might use it to cover closing costs for a new mortgage. You can also use a bridge loan to present an offer without a financing contingency when you make an offer to purchase a home. A financing contingency is a contract clause that allows a buyer to get back money put down without penalty in the case the buyer cannot secure financing. Sellers tend to prefer offers with fewer contingencies, but it’s important to have protections in place in case you can’t secure funding. A bridge loan can also help you get a leg up over other buyers in a hot housing market. For example, if a seller is interested in a quick sale (and many are), the seller may be more willing to make a good deal for a buyer who has the money to close quickly.
Bridge loans typically must be repaid within 12 months or less. Most people pay off their bridge loan with money from the sale of their current home, but there are other repayment options. Bridges loans may be structured in a number of different ways but commonly have a balloon payment at the end where the full amount is due by a certain date. You may be able to wait a few months after the close of the bridge loan before you have to start making payments, though this will depend on the particular loan you have been approved for.
Pros And Cons Of Bridge Loans
As with any loan product, bridge loans have potential advantages and potential disadvantages for borrowers. Before applying for any kind of loan, it’s important to understand and weigh the pros and cons.
Pros of bridge loans
• Faster financing: The application process and closing on a bridge loan typically takes less time than other types of loans.
• Purchasing flexibility: Getting approved for a bridge loan can give you the funds you need to close on a new home before you sell your current one. That means if you find a home you love, you might be able to buy it without waiting for your old home to sell.
• Remove contingencies from your offer: Sellers may look more favorably on purchase offers that aren’t contingent upon the sale of another home.
• Less housing hassle: You can use a bridge loan to help buy a new house before selling an existing home.
Cons of bridge loans
• High interest rates: Since lenders have less time to make money on a bridge loan because of their shorter terms, they tend to charge higher interest rates for this type of short-term financing than for conventional loans.
• Origination fees: Lenders typically charge fees to “originate” a loan. Origination fees for bridge loans can be high as much as 3% of the loan value.
• Equity required: Because a bridge loan uses your current home as collateral for a loan on a new home, lenders often require a certain amount of equity in your existing home to qualify, for example 20%.
• Sound finances: To be approved for a bridge loan typically requires strong credit and stable finances. Lenders may set minimum credit scores and debt-to-income ratios. Generally speaking, if your financial situation is shaky, it could be difficult to get a bridge loan.
Perhaps the biggest risk of a bridge loan is that if your home doesn’t sell by the time you need to begin repaying your bridge loan, you’re still responsible for the debt. Until your old home sells, you’ll essentially be paying three loans: the two mortgages on the houses and then also the bridge loan. And because the bridge loan is secured by your first home as collateral, if you default on your bridge loan, the lender may even be able to foreclose on the home that you are trying to sell.
Equity Bridge Financing
Bridge loans imply a very high interest rate, and it is not acceptable for every company. Instead, companies are ready to exchange capital for an equity portion of the company. In such a case, venture capital firms will be approached instead of banks and offered equity ownership. Venture capital firms will go for a deal in case they assume the company will succeed and become profitable. If the company becomes profitable, it means that the value goes up, and thus the venture cap’s stake increases in value. Bridge financing is used before a company goes public, offering its shares on a stock exchange to investors. Such a type of financing is originated to account for IPO expenses the company needs to incur, such as underwriting fees and payment to the stock exchange. Once the company’s raised money during the IPO, it will immediately pay off the loan. The bridge funds are typically provided by an investment bank that will underwrite the new stock issue. The company will initiate a number of shares to the bank at a discount on the original price offered to the investors during the IPO. It is a so-called “offsetting effect.” Financial managers responsible for negotiating term loans from commercial banks often feel confronted by a stone wall—the banker’s restrictions (restrictive covenants) on the company to ensure repayment. While the ultimate objectives are easily understood (getting the least expensive funds under the fewest restrictions), achieving them is not. Since the first caveman loaned a spear to a friend only to have it returned the next day broken into little pieces, lenders have been cautious in dealing with borrowers. Moreover, lenders know they have a certain power over borrowers and have turned it into a mystique. Unlike the case in other contract negotiations, many borrowers feel they have few, if any, cards to play; that is, they have to take most of what the banker decides to dish out.
Inside the Banker’s Head
First, let’s look at the two sides in this contest. At the outset the bank’s perspective is built on an objective and subjective analysis of the borrowing company’s financial position. The analysis rests on that well established tenet permanent asset needs should be financed with permanent capital. When permanent capital takes the form of long-term debt, the lender wants to find out how healthy the borrower’s long-term earning power is. So the bank asks for financial information as start historical financial statements (typically five years) as well as a forecast of your company’s income statement, balance sheet, and the sources and uses of funds statements for each year. The bank’s principal and interest will be returned from the future stream of earnings before interest and taxes (EBIT).
(Normally, a bank calculates EBIT as sales less cost of sales less selling, general, and administrative expenses.) Consequently, the bank wants to learn the extent of business risk—in other words, how much the future EBIT stream could vary. Another important element is understanding the borrower’s industry both the company’s strengths and weaknesses and its overall strategy. (While EBIT is available to cover interest expense, principal payments, not being tax deductible, must be paid out of the net income stream. Moreover, annual principal payments cannot be made out of “cash flow” [net income + depreciation] unless the borrower can forgo replacing depreciated fixed assets.)
Banks consider some lines of business inherently risky and this will influence the analysis, but the financial forecast becomes the primary basis on which the banker quizzes the manager to determine the degree of business risk.
The banker also uses the forecast to establish how restrictive the loan will be. Bankers also put considerable emphasis on the company’s historical earnings record as an indicator of business risk. Wide fluctuations in profits or net losses or consistently thin profit margins usually lead to an assessment of high business risk. After the EBIT stream, the company’s balance sheet is the most important financial indicator because the assets are the bank’s secondary source of repayment if earnings are not adequate to repay the loan. Therefore, the assessment of balance sheet strength or weakness hinges on the extent to which the banker thinks the loan is recoverable if assets must be sold. Judgment is largely based on a few key ratios. For example, the current ratio or net working capital position represents the amount of liquid assets the company has available to repay debts. The banker also investigates fixed asset liquidity, important in the event of financial distress or bankruptcy.
The Making of Restrictions
Bankers use these simple financial indicators to determine the scope and severity of the restrictions placed on a potential borrower. The five possible types of restrictions include cash flow control, strategy control, the default “trigger,” balance sheet maintenance, and asset preservation.
Cash Flow Control
The first source of restrictions comes directly from an analysis of cash flow. A company may want to build its assets so rapidly or pay such excessive dividends that the banker questions whether the EBIT stream will be sufficient to service the loan. In this case, repayment must come from a refinancing by another creditor or an equity sale. If the bank is confident that the company’s earnings record and balance sheet will be strong enough to permit refinancing, it will not seek to control the company’s cash flow. However, even when refinancing appears possible, bankers will usually limit excessive dividends and stock repurchases to preserve the company’s equity base.
The lender may try to control future strategy if he or she believes that the company’s resources are ill-matched with the opportunities and risks present in the environment or when a particular strategy requires an imprudent degree of leverage of illiquidity. Resulting covenants either prohibit managers from implementing the strategy or force them to modify it. In such cases, bankers usually want to reduce the total amount of money invested in a particular product market or spread the investment out over a longer time period, either by limiting capital expenditures and acquisitions or by writing in a debt-to-equity test.
The Infamous Trigger
One of the most feared aspects of restrictions is the bank’s right to call the loan, or trigger a default. The readiness of the trigger depends on the strength of the balance sheet and the degree of business risk that is, the potential variability in EBIT. Losses erode company assets by reducing the net working capital and the equity base.
In that event (or possibly if profitability declines), the banker wants the right to call the entire loan for repayment before deterioration advances. If the company cannot repay the loan, the bank has legal recourse on the assets. Banks, however, seldom pull the dreaded trigger. Such action usually means bankruptcy for the company, adverse publicity for the bank, and a time-consuming, costly legal proceeding for both parties. In most cases, if the restrictions trigger a default the loan is not called; instead, this imminent possibility forces the borrower to return to the bargaining table. The banker then wants a proposal for corrective action. In return for continuing the loan, the bank can boost the interest-rate demand collateral as compensation for the risk or else rewrite the covenants.
Balance Sheet Maintenance
A company can harm its balance sheet by excessive leveraging or by financing fixed assets with short-term loans, both of which reduce its net working-capital position and liquidity. To keep the borrower from wantonly employing short-term credit, lenders impose a current ratio and/or net working-capital minimum. Also included is a debt-to-equity limit or even a prohibition on additional borrowings.
Because bankers regard assets as the ultimate source of repayment, they do not want to see a significant portion sold or pledged to other creditors. So, unless the loan is secured, lenders will write in a limit on the extent to which companies can pledge assets (a “negative pledge clause”). Even if the company can put up sufficient collateral, the bank will restrict the sale of assets to forestall disposal for less than their value or for securities that could prove worthless. The bank will place limits on asset sales or require that any sale be made at fair market value in cash and that the proceeds be used to reduce the loan or to acquire replacement assets.
Principal Rules Of Loan Negotiation Hold
• Consider your earnings history over the past five years. Losses, consistently low profit margins, or very volatile earnings usually indicate a great degree of business risk.
• Ask yourself whether the variables that determine EBIT (e.g., raw material costs, sales volume, product price, foreign exchange rates) will change over the life of the loan and cause severe declines in earnings.
• After taking into account the loan, look at the existing and forecast balance sheet ratios such as the debt-to-equity ratio and the current ratio. Do they indicate an illiquid or highly leveraged condition? (If a company’s forecast is based on assumptions that are overgenerous in view of historical results, a banker will frequently draw up a forecast with more conservative assumptions. Try it yourself. In that case, can the debt be serviced? What happens to the leverage and liquidity ratios?)
• Considering the types of assets the company owns, the net working capital level, and the margin of safety for creditors (leverage), could the bank get repayment if the company’s assets were liquidated? If the answer is yes, then yours is a strong-balance-sheet company. If the answer is no or maybe, then yours is a weak-balance-sheet company.
The smart manager will insist that the banker can achieve many objectives through a single covenant. For example, the debt-equity ratio restriction can control management’s use of leverage and also serve as the yardstick for a trigger if the company incurs losses. If the banker proposes a net worth minimum as a trigger and a debt-equity ratio as a brake on leverage, the manager can argue for elimination of the trigger because the debt-equity ratio is a sufficient control. The banker may counter by maintaining that he wants to safeguard loss control directly, but the borrower may at least get the restrictions relaxed somewhat.
Dealing with Strategy Control
A strategy restriction often leads corporate executives to seek a more “enlightened” bank. Unfortunately, if one bank thinks this kind of control necessary, usually most others will agree. Rather than shopping around, find out why the banker objects to a strategy; then point out your thinking behind it and the importance of flexibility. After all, success here should guarantee future earnings power. Then agree to other restrictions—for example, a tight trigger that allows the bank to put a stop to the strategy if it results in losses. If, after considerable discussion, the bank officer continues to regard the plan as inappropriate, consider financing from a source less averse to risk than a commercial bank.
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