Short-term finance has become one of the fastest-growing financial products in the UK, with annual total lending increasing from £0.8 billion in 2010 to £2.2 billion in 2014 – a huge increase of almost 300%! This is due in part to the global financial recession: high street retail banks are still wary of approving loans, and this has restricted the types of funding available to businesses and individuals. The nervousness of retail banks isn’t the only reason for short term finance’s popularity; the competitive rates that the funding offers and the many uses it can be put to make it an attractive solution for many different borrowers.
What is short term finance?
Short term finance is, essentially, a way of obtaining a large loan relatively quickly, by trading equity in an asset for cash. By using existing assets to secure a loan, businesses and individuals are able to take advantage of opportunities as they arise, something that can be difficult to do with long-term loans. This is because long-term loans typically require a greater degree of time and security to arrange, and are therefore not suitable in situations where money is needed quickly to begin a project.
Short term financing is commonly used to get the ball rolling on projects where there is no option to arrange a long term loan – if a company needs to purchase a brownfield site before beginning development, for example, they wouldn’t be able to apply for a construction loan, and so would need an alternative source of finance. Similarly, houses bought at auction typically need to be paid for within 28 days, a period which is much too short to arrange the surveys and paperwork required for a mortgage, but a reasonable timeframe for arranging a short term financing solution.
Is it expensive?
A short-term loan is more expensive than a long-term loan, because the interest is charged monthly rather than annually. However, it can be deceptive to compare the two types of loan; though a bridging loan offered at 1% per month may theoretically have a staggering 12% APR, if the loan is paid back within two months then the total cost of the loan is kept to a reasonable 2%.
Depending on the lender, the size and length of the loan, and the ratio of loan to value, there may also be an arrangement fee of several percent payable before the loan is approved. Though similar in practice to mortgage arrangement fees, the fact that it’s calculated as a percentage of the total loan value can make the upfront fees of short term financing quite expensive, a factor that should be considered before pursuing one.
As previously mentioned, competition has driven down the costs of a typical short term finance package, so although it can still be a fairly expensive way to arrange financing, short term loans are becoming more and more affordable.
How much can be borrowed?
Short term financing is a very flexible product, and can be used for anything from refurbishing a private home to renovating an entire block of flats. As such, there are many diverse companies offering different scales of finance – many companies offer funding from £30,000 up to £25 million, though projects of up to £50 million can be funded by specialist short term financiers.
The amount that can be borrowed is determined by the value of the asset it is secured against, with most short term finance options having a maximum loan-to-value ratio of 75% (though there are some exceptions to this). This means that a short term loan secured against a £500,000 property could not be for more than £375,000. If the property is already mortgaged (i.e. there is already a “first charge” on it), the LTV typically drops to around 65%. This reflects the increased risk that is incurred as a “second charge” lender, as the first charge lender will take first priority if the asset should be repossessed.
How is short term financing regulated?
As part of the consumer credit industry, short term financing used to be regulated by the Office of Fair Trading. In 2014, though, regulation of the industry passed to the newly-created Financial Conduct Authority (a subsidiary of the Bank of England and close cousin to the Prudential Regulation Authority), which has the power to set minimum standards, investigate any business or individual and order limited or indefinite suspensions of any product.
Because some aspects of short term finance are used in similar situations to mortgages, there are certain situations where mortgage regulators require short term loans to comply with their rules – if a loan is secured against a residential property in which the borrower is living, for example. The pan-European Mortgage Credit Directive has certain requirements for mortgages made on mixed-use properties which aren’t applicable under UK law, and are in line to be implemented in 2016. However, it is unclear how the UK market will be affected by these changes, and whether the EU commissions directives will be interpreted as the UK moves to leave the EU.
The importance of an “Exit Strategy”
Because short term finance companies are typically funding money “up front” for schemes, they typically require borrowers to prove that they have an “exit strategy”. This is the borrower’s plan to repay the loan; a homeowner repaying with the balance of their mortgage, a renovation company repaying with the proceeds of a house they’ve sold, or a retail company repaying with the profits of their new establishments.
Any company you approach for a short term finance loan will need to approve your exit strategy before agreeing to loan you the money. Depending upon the size of the project (and the loan), they may decide to “stress-test” your exit plan, testing your ability to repay if things don’t go according to plan. Before applying for a loan like this you should be certain of your repayment plan, and have paperwork to prove its viability.
What are the dangers of short term finance?
The biggest danger in short term finance is overconfidence; if you take on a loan that’s too large for you to repay, or without a 100% guaranteed way of repaying it, you’ll find that interest charges pile up faster than they can be cleared. This is why companies will require you to provide a clear and coherent exit strategy before they’ll approve you loan. Don’t be tempted to misrepresent your situation; being approved for a loan when you shouldn’t be can cause you enormous problems if you struggle to repay.
There are plenty of small, one-man outfits within the market, but bigger City firms with more experience, more resources and tougher regulations will be a safer bet for borrowers.
Finally, don’t be tempted to take out a short term loan if it’s not right for you – recently, the FCA has expressed concern that some financial advisers might be suggesting loans to people when they’re not the best option; a full understanding of exactly what rules there are surrounding your loan is the best defence against poor advice, so the more information you can gather the better!
Different types of Short Term Finance
As the market has become more crowded, competition has forced short term finance companies to offer better and better terms to customers, resulting in quick, easily arranged loans at highly competitive rates. With increased regulatory oversight and growing consumer confidence, short-term finance is highly flexible and offers many benefits to both individuals and businesses. The remarkable proliferation of short term financing has led to intense diversification and specialisation within the market, with companies providing loans for every situation.
The sheer variety of products available can be overwhelming, though, which is why we’ve broken down some of the most common types of finance available, so you can better understand how short-term finance can work for you.
Also known as “swing” loans or “caveat” loans, bridging finance is used to plug the gap between two large, long-term loans. Typically, this type of short term financing is used by homeowners to escape the “chain” of real estate associated with moving house, or by property developers looking to secure a site before beginning development.
For example, a home seller might benefit from this type of finance by paying a deposit on their new home before they receive the funds from their own sale. By doing this they’re able to secure the new property without having to wait for their current one to sell, and they avoid the possibility of the seller pulling out. “Breaking the chain” like this is an attractive prospect to anyone who’s been stuck in a months-long cycle of “will they, won’t they”, but although it can allow you to secure your new home before your own buyer completes, if your buyer pulls out you could find yourself accruing interest on a short-term loan with no mortgage repayment to pay it off with!
If short term financing is secured against a property within which the borrower or a close relative of theirs is living, it is treated as a mortgage by the FCA. This means it will be regulated as such, and will be subject to their conditions of repayment, including repossession in the case of no-payment.
Because short term loans are designed to be repaid within a few months, the rates available on them are typically higher than those on longer-term finance options. Therefore, the bridging loan should be repaid immediately once funds become available from other sources; the loan is only a temporary measure that allows you to exchange equity for liquid assets. Bridging loans are flexible, and are typically offered in amounts from £0.5 million to £3 million.
Refurbishing an old home is a great way to turn a profit: old, musty properties can often be had at a knock-down price and with a little elbow grease and investment can be sold for well above what they were bought for. Of course, the biggest improvements bring the biggest profits, but turning a fixer-upper into a kerbside stunner takes money that might not be easy to come by. A short-term refurbishment loan allows you to renovate a property without putting the builders on standby every time cash is in short supply. It also allows enterprising customers to renovate dilapidated houses into a mortgageable condition, something that’s not easy to achieve without finance.
Loans of this type are typically for larger-scale renovations, such as structural alterations, extensions and multiple-unit refurbishments, and are most often offered over a longer period than bridging loans are. This type of finance is typically available for under a year and for amounts between £0.5 million and £1 million.
For large-scale developments like blocks of flats or residential areas, a specialist development finance company will offer a larger, longer-term loan. Though the interest rates on a development loan are higher than traditional finance options, these loans are often available in cases where a bank loan wouldn’t be and so provide development companies with options for finance where they’d otherwise be forced to sell assets or pass up the opportunity.
Often, a property developer will use a development loan to begin work on a project that hasn’t been granted planning approval and so isn’t eligible for a long-term loan. This allows the developer to avoid lengthy delays to their schedule, and once planning approval is granted they can take out a construction loan to finance the project.
Though similar in type to regular refurbishment loans, development loans are usually of another order of magnitude; they can be up to £30 million pounds for large-scale projects and the smallest start around £5 million.
Commercial funding is a type of short term finance which empowers developers to begin work on projects quickly, to take advantage of opportunities as they arise. For example, a retailer might wish begin developing a new retail park, or refurbishing their entire chain of stores, but be unable to secure a loan with which to do so. Through short term financing they can initiate a project, and use the increased profits that result to repay the loan.
Commercial financing is often provided through the partial or exclusive use of “mezzanine funding”, a hybrid of equity and debt which provides the lender with a portion of equity in the company should the loan not be repaid on time. This allows borrowers to essentially secure the loan against their own company, rather than against an asset; the equity of the company functions as the security, (although since it isn’t an asset, the loan is unsecured). Mezzanine financing is typically only available to companies with a proven track record and quality product, as it carries a greater risk to the lender, and usually attracts a high interest rate with an expected return of between 20-30%.
Self-build finance is how Grand Designs gets made; securing a mortgage for a home that you plan to build yourself over the course of several years is nigh-on impossible in the current climate; no retail bank will touch self-builders with a bargepole. Self-build loans allow architects to bring their blueprints to life by providing medium length funding that keeps the builders onsite until the project is completed. Typically, a self-build loan will be between £1 million and £3 million, though this of course can vary depending on the project requirements.
Buying houses at auction requires an immediate down payment on the property, and for the purchase to be completed within 28 days. Anyone who’s been through the process of arranging a mortgage can attest to the fact that it takes a lot longer than 28 days to sort out, so arranging a short-term finance solution with which to pay for the property allows buyers to acquire auction properties quickly and easily. Once the property is in the buyer’s possession, they can either arrange a long-term loan solution (like a mortgage), or refurbish and sell the property for a profit.
Short-term financing for agricultural concerns is typically used to fund renovations or improvements to the estate, by investing in infrastructure such as hunting lodges, stables, shops or farm equipment. The increased profitability of the estate can then be used to repay the balance of the loan, or as a way to sell the property for a higher price with the loan being repaid from the proceeds of the sale.
Short term finance is a global industry, with financial solutions available across many different countries. Consumer credit can be provided by companies in the UK to customers overseas, but this usually requires the services of a specialist lender, as not all companies are able to arrange finance across borders. Short term finance is typically only available for loans with terms longer than a year for international customers, though the total amount available may be unaffected.
Official resources about UK regulatory bodies:
- National Association of Commercial Finance Brokers (NACFB)
- Association of Bridging Professionals (AOBP)
- The Association Of Short Term Lenders (THEASTL)
- The Financial Conduct Authority (FCA)
- Bank of England Website
- Prudential Regulation Authority
- Financial Conduct Authority
- The Financial Policy Committee
- Financial Services Compensation Scheme
Other Unofficial Short Term Finance Guides
Covering areas of UK financial regulation and aspects of Bridging Finance.
Short Term Finance bridging guide provided by: Bridging.com