What Is a 125% Loan?
A 125% loan is a leveraged loan, often a mortgage used for refinancing a home, that allows homeowners to borrow an amount equal to 125% of their property’s appraised value.
For instance, if a home is valued at $300,000, a 125% loan would enable the borrower to access $375,000 in funds.
Key Highlights
- Higher Value Loans: A 125% loan offers a mortgage equal to 1.25 times the property’s appraised value.
- Rising Risk: Popular in the 1990s, these loans became increasingly risky and unmanageable during the 2007–08 housing crisis.
- Interest Rates: Due to higher risk, 125% loans come with significantly higher interest rates compared to traditional mortgages.
- Current Availability: While less common today, some lenders still offer 125% loans.
Understanding How a 125% Loan Works
In finance, a 125% loan has a loan-to-value (LTV) ratio of 125%. The LTV ratio compares the loan size against the appraised property value and helps lenders assess the risk of default. A 125% loan is riskier than those with LTV ratios below 100%—traditional mortgage loans usually don’t exceed 80% of a property’s value.
Because of higher risk involved, a loan with an LTV ratio of 125% typically carries much higher interest rates, possibly double those of loans with lower LTV ratios due to risk-based pricing methods used by lenders.
The Potential of a 125% Loan for Refinancing
Homeowners often use 125% loans for refinancing to access more cash than available home equity. The funds from such loans are typically used to pay off high-interest debts, like credit cards.
However, with higher interest rates and potential additional fees, prospective borrowers should diligently shop around for the best terms. Home equity loans or cash-out refinances offer alternatives with potentially lower interest rates and yet provide funds to settle high-interest debts.
Pros and Cons of 125% Loans
- Advantages: These loans provide homeowners, especially those with little or declining home equity, the benefit of obtaining more cash than they would otherwise qualify for.
- Disadvantages: They come with higher risks for both the borrower, who takes on more debt, and the lender, who faces greater risk of default. In a default scenario, lenders are unlikely to recoup all their funds even through property foreclosure and sale.
Historical Perspective on 125% Loans
The 125% loans gained traction during the 1990s, often targeted at low-risk borrowers with excellent credit scores aiming to borrow more than their home equity allowed. These loans significantly contributed to the 2007–08 housing crisis. The real estate market collapse led many homeowners to owe more than their home’s actual worth.
Following this, the now-expired federal Home Affordable Refinance Program (HARP) was introduced in 2009 as a relief measure. HARP allowed homeowners who owed up to 125% of their home’s value to refinance at lower rates. The program eventually encompassed even more homeowners by lifting the 125% LTV ceiling before ending in December 2018.
Defining 125% Financing
When refinancing, homeowners can opt for a 125% loan, borrowing an amount up to 125% of the appraised home value. This scenario is beneficial in situations where the house’s value is lower than the owed amount.
Exploring 90% LTV Loans
A 90% LTV loan implies a loan-to-value ratio of 90%. For example, on a $300,000 home with a $270,000 mortgage, the LTV ratio would be 90%, necessitating a 10% down payment. While 20% down payments are common in the U.S., resulting in an 80% LTV, 90% LTV loans are also options albeit with specific criteria.
Extracting Home Equity Without Refinancing
Homeowners can access their home equity without refinancing through home equity loans, home equity lines of credit, and home equity investments.
Related Terms: loan-to-value ratio, risk-based pricing, cash-out refinance, home equity loan.
References
- American Banker. “A 125% LTV Loan Unlike Yesteryear’s”.
- AwesomeFinTech. “125% Loan”.
- Federal Reserve History. “Subprime Mortgage Crisis”.
- ABC. “How Will the Federal Home Affordable Refinance Program Help Owners?”
- Federal Deposit Insurance Corporation (FDIC). “Relief RefinanceSM/Home Affordable Refinance Program (HARP)”.
- Federal Housing Finance Agency. “Refinance Report: First Quarter 2019”, Pages 1,4.
