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What are bridging loans?

Bridge loan or bridge financing refers to a type of short term loan, which is used until the individual or company has arranged for a longer term or permanent financing. As the term implies, this type of loan is generally used as an interim source of funds to solve temporary liquidity problems, to "bridge the gap" during financial distress.

Reasons for "bridging"

Individuals & companies need temporary funds to tide over circumstances they may be facing, such as:

  1. In case where a company has applied for loan, pending procedural snags or legal documentation - which may take time to complete. Such a company may need the funds urgently, & until such time the loan formalities are completed, temporary funding is useful.
  2. Real estate developers or infrastructure developers may need funds for newly commenced projects - but traditional financing may not be forthcoming since the project is pending clearance. Although the clearance may be expected soon, the regular lenders may not extend finance.
  3. Individuals who are in the process of purchasing a new house need funds to pay for their purchase until their old house is sold or funds are released from other ill-liquid sources.

These are only a few situations where bridge financing or gap funding is needed. Innumerable other situations may arise when funds may be required at short notice & without excessive processing time. Bridge funds cater to such needs of users, which enable them to clinch a deal, or inject some cash into their businesses & stay afloat.

How does it work?

Bridge loans are considered non standard loans & only a few lenders offer such loans. Moreover, the circumstances of each borrower may be different, the lenders have to evaluate the requests individually. The lenders initially assess the risk profile of the borrower & find out the repayment capacity as well as time frame of repayment. The lenders also look for securities that the borrower can pledge & work out its valuation. Depending on the valuation & marketability of the security, the lenders assess creditworthiness of the borrower & maximum amount that can be lent. This is also called loan to value ratio. All of this is done quickly enough so that the funds are released at the earliest. The loan is disbursed with minimum required documentation & procedural formalities. Once the borrower is able to secure long term or permanent funding, the bridge loan is repaid with the proceeds derived from the long term funds. Lending duration of bridge loans may range from a few months to about three years. Usually, bridge loans are supposed to be repaid within twelve months. However the lender may extend the duration of the loan or renew the loan based on risk assessment & securities offered by the borrower. The repayment schedule of such loans are customized to individual requirements.

Interest cost

The expense incurred on bridge finance is always more than regular finance. This is due to the fact that interest charges are composed of two charges:

  1. Cost of funds lent
  2. Risk Premium

Risk premium is a charge to compensate the increased risk undertaken by the lender. Risk premium is based on the risk assessment made initially & on the nature & value of security offered to cover for the loan. Risk premium is typically higher when the loan to value ratio is higher, or the specific circumstance in which the borrower requests for funding is uncertain & risky. For instance, a real estate developer may commence with some of its activities such as procurement of materials or purchase of land without obtaining requisite permits - in the expectation that the permits & approvals will be received soon. Or, an individual may book a new house on the expectation that the existing house will be sold in due course. But in order to book the new house, bridge funding is required. Both the above situations give rise to significant risks undertaken by the lender. This drives up the costs of such short term funding. In addition to interest costs, other processing charges may be charged too. Interest costs are usually in the range of 10 to 15 percent but may be more based on the circumstance & lender.

The benefits that the borrower can expect is quick funding, avoidance of delay, & not missing out on deals. Companies which may require urgent working capital funding due to unexpected & sudden changes in the economic environment are amongst its beneficiaries. Sudden hike in demand for goods may increase the strain on the working capital & manufacturing facilities. Such situations can be effectively handled with additional gap financing. Companies which are in the process of raising equity or debt capital for investments in project need not wait for the listing formalities in the stock exchanges. Sick companies may use such funds to stay afloat until owners infuse cash or a buy out happens. Individuals who wish to buy a new house need not sell their old house or other less liquid assets under distress. They can wait till their assets command the right price.

There are significant & noteworthy risks related to borrowing such funds. First of all, the borrower has to pay an increased cost for such funds. This affects margins & reduces profitability. Also, taking over another loan adds to the strain on the balance sheet of the borrower. It adds to the cash outflows of the firm, thus further endangering liquidity & solvency position of the firm. Many a times, the lenders ask for cross collateralization of securities, to reduce their risks. This means, security used to finance one loan may be used for any other loan that might be pending repayment. Thus, in case the company fails to pay any one loan, its assets will still be under charge. Cash outflows need to be estimated & planned such that the loans are repaid on time, without affecting its liquidity & regular operations.

Individuals & companies need to understand the reputation risks of defaulting on loans. Thus companies & individuals should carefully weigh the benefits accrued against the risks borne & expenses incurred. These loans should be considered as a last resort only. Borrowers must avoid piling up debts on their balance sheets so as to maintain debt equity balance & stable liquidity position.