What is a 125% loan?
A 125% loan is a loan – usually a mortgage – the initial amount of which corresponds to 125% of the initial value of the property. For example, if your home is worth $ 300,000, a 125% loan would allow you to borrow $ 350,000.
These loans became common in the 1990s. Originally designed for borrowers with high credit scores and exemplary credit histories, they tend to carry substantial interest rates, as much as double those of Standard mortgage loans.
How a 125% loan works
In the language of technical financing, a 125% loan has a loan to value ratio (LTV) of 125%.
A primary measure of the risk of a loan to a lender is the size of a loan relative to the value (LTV ratio) of the underlying property. A 125% loan is a relatively risky loan compared to a loan with an LTV ratio of less than 100%: in conventional mortgages, the size of the loan does not exceed 80% of the value of a property. Therefore, depending on the risk-based pricing method used by lenders, a loan with an LTV ratio of 125% will carry a higher interest rate than a loan with an LTV ratio of 100% or less.
Because they involve a sum greater than the value of the mortgaged property, a 125% loan carries higher interest rates than conventional loans.
Homeowners can look for a 125% loan as a refinancing option to give them more access to capital. Their motive could be to use the loan as a means of paying off other debts that carry higher interest rates, such as credit cards. The relatively lower interest rate on the mortgage could mean smaller payments and a lower principal balance, which would increase principal more quickly.
Example of loans at 125%
Returning during the 2007-08 housing financial crisis, 125% of loans played a role in helping homeowners. The collapse of real estate markets across the country, triggered by the collapse of subprime mortgages, left many people “under water”, meaning they owed more money on their mortgage than the house was really worth. It was not uncommon to find homeowners in debt to pay off mortgages whose rates and principal balance no longer reflected the value of the homes for which they paid. As the value of homes dropped, homeowners might want to refinance, but to be eligible, they might have been required to have paid a certain percentage of the home’s equity. Drastic market changes have made it difficult to secure refinancing; furthermore, continuing to pay down their existing mortgages would likely mean that they could not recover their losses even if they tried to sell the house.
The Federal Affordable Home Refinancing Program (HARP) was created in March 2009 to provide relief. It allowed homeowners whose homes were underwater, but who were otherwise in good standing and up to date with their mortgages, to apply for refinancing. Thanks to HARP, homeowners who owed up to 125% of the value of their homes could seek refinance at lower rates to help them pay off debts and solidify financially. Originally, homeowners who owed more than that percentage could not apply, but ultimately even the 125% LTV limit was removed, allowing even more homeowners to apply for HARP loans.
After being extended several times, the HARP program ended in December 2020.