What Is a Bridge Loan and How Does It Work?

For tackling short-term financial requirements, a bridge loan can provide quick liquidity and help manage immediate cash flow gaps. It is particularly useful when urgent funding is required but not readily available, making it a viable option for both businesses and individuals.

To determine whether bridge financing is the right option for you, it’s essential to explore its types, advantages, and drawbacks.

In this article, we will examine the key aspects of bridge lending, along with alternative options such as unsecured business loans, loans against property, and loans against securities.

What Is a Bridge Loan?

A bridge loan is a short-term financing solution that helps meet immediate financial needs until long-term capital becomes available.

Essentially, it bridges the gap between current financial requirements and future capital inflows.

Borrowers usually use bridge finance loans to cover temporary cash flow gaps, such as covering operational expenses during seasonal revenue fluctuations.

Bridge loan financing generally lasts from a few months to a year and carries higher interest rates due to its short-term nature and the lender's associated risk. These loans often require collateral, such as real estate or business assets, to secure the funding.

Types of Bridge Loans

1. Closed Bridging Loan

A closed bridging loan is a short-term financing option with a fixed repayment period. The borrower has a clear exit strategy, typically a confirmed property sale or a pre-arranged long-term loan.

The fixed repayment terms reduce risk for both borrowers and lenders. Because repayment is guaranteed within a set timeframe, closed bridging loans typically have lower interest rates than open ones. However, penalties may apply if the borrower defaults.

2. Open Bridging Loan

An open bridging loan offers more flexibility, as it does not have a fixed repayment date. 

However, this flexibility comes at a cost – open bridging loans usually carry higher interest rates because lenders take on greater risk. In some cases, lenders deduct interest upfront from the loan amount. Borrowers typically choose this option when they are uncertain about when they can repay due to financial constraints.

3. First Charge Bridging Loan

In this type of financing through bridge loans, the lender holds the primary claim on the collateral in case of default, meaning they stand to recover their money before other lenders.

Since these loans provide greater security to first-charge bridge lenders, they often come with lower interest rates compared to second-charge loans.

4. Second Charge Bridging Loan

This is where the second-charge bridge lender holds a secondary claim on the borrower’s collateral, ranking behind the primary lender. If the borrower defaults, the first lender is repaid first, and the second lender receives any remaining funds.

This type of financing may be used when a borrower needs additional funds beyond an existing secured loan.

How Do Bridge Loans Work?

Let’s understand how business bridge lending works with an example.

Suppose a business owner wants to expand operations by acquiring new equipment, but their expected revenue from pending client payments is delayed. They need immediate funds to secure the equipment but lack sufficient working capital.

As a quick loan solution, they take a bridge loan, which allows them to acquire the equipment without waiting for incoming payments.

Once the pending client payments are received, the business can repay the bridge loan.

Pros of Bridge Loans

The advantages of bridge loans include:

• Flexibility: Available as open or closed loans, allowing borrowers to choose repayment terms that align with their financial situation.
• Supports Business Growth: Small businesses can use bridge loans to manage operational costs or expansion until permanent financing is arranged.
• No Long-Term Commitment: Bridge loans typically have short repayment periods, ideal for borrowers who want to avoid long-term debt obligations.

Drawbacks of Bridge Loans

A bridge loan is not suitable for everyone. Let’s consider the drawbacks of this loan option:

• High Interest Rates: Since bridge loans are short-term and carry higher risk, they have higher interest rates despite the presence of collateral.
• Risk of Losing Collateral: If the borrower fails to repay, the lender can seize the collateral, such as property or assets. This can result in substantial financial losses for borrowers.
• Additional Fees and Costs: Lenders may charge various fees, including processing fees, which can significantly increase the overall loan costs, especially given the high interest rates.

Conclusion

While a bridge loan for business or personal needs can provide quick access to funds, it may not be the ideal solution for everyone due to its short-term nature, higher interest rates, and collateral requirements.

For business owners exploring financing options, an unsecured business loan of up to INR 75 lakhs* from SMFG India Credit offers competitive interest rates without the need for collateral. If you require a larger loan amount with greater flexibility in fund usage, consider a loan against property or a loan against securities. These secured loans provide substantial funding at attractive interest rates.

Apply online today or contact us to find the right financing solution for your needs.