What it means
Most mortgages cap borrowing at a share of the property value, which is described by the loan-to-value ratio (the loan divided by the home's value). A 125% loan breaks that rule, because a borrower with a $200,000 home could borrow $250,000, leaving the borrower owing $50,000 more than the property is worth.
These products became popular in the late 1990s, when lenders were keen to lend against homes and borrowers wanted to clear credit cards and personal loans. The home secured the first 100% of the loan, while the final 25% was in effect unsecured, so it was priced more like a personal loan than a mortgage.
For the borrower, the appeal was a single monthly payment and an interest rate lower than that on credit cards. The risk, however, is large, because the home has to rise in value just for the borrower to break even.
If house prices fall, the borrower can end up with negative equity (owing more than the home is worth). Selling then does not clear the debt, and the borrower must find cash to pay off the shortfall, in addition to selling costs.
Lenders respond to the extra risk by charging higher interest rates, requiring strong credit scores and sometimes adding fees. Interest on the portion of the loan above the home's value is generally treated differently for tax, so a borrower should seek advice before assuming it is deductible.
Such loans are uncommon in many markets because regulators and lenders have become more cautious about high loan-to-value lending. Where they are offered, they should be seen as expensive and risky, and a borrower should compare them with alternatives such as a personal loan or a debt consolidation plan.
In practice
Real-world examples.
Example
A couple in the construction trade has a home worth $240,000 and credit card debts of $45,000. A lender offers a loan of $300,000, which pays off the existing mortgage of $255,000 and clears the cards. Their monthly payments fall, but their debt now exceeds the value of the house.
Example
A small business owner is considering borrowing 125% of the value of his home to fund a kitchen renovation. His adviser points out that the improvement may add far less value than the cost of the loan. He decides to borrow only what the home can fully secure.
Example
A mortgage investor reviews a pool of high loan-to-value loans purchased from a lender. She notes that falling local house prices would push most of the loans into negative equity at the same time. She prices the pool at a discount to cover the higher expected losses.
Formula
Calculation
Loan-to-value ratio = Loan amount / Property value
Equity = Property value - Loan amount
Suppose a home is worth $200,000 and the borrower takes a $250,000 loan. Loan-to-value ratio = 250,000 / 200,000 = 1.25, or 125%. Equity = 200,000 - 250,000 = -$50,000, so the borrower starts out with negative equity of $50,000. If the home is sold for $200,000 and selling costs of 6% are paid, 200,000 x 0.06 = $12,000, leaving $188,000, the borrower would still owe 250,000 - 188,000 = $62,000.Case study
Seen in the real world.
Redwood Home Finance is an illustrative, fictional lender that offered 125% loans in a booming regional housing market. It charged an interest rate of 9% on the full amount, a few percentage points above a normal mortgage, and its finance team expected losses of about 2% of loans a year.
When local house prices fell 15%, a typical borrower with a $200,000 home and a $250,000 loan saw the home fall to $170,000, leaving a gap of $80,000. Defaults rose well above the original forecast.
Redwood's board concluded that the interest premium had not compensated for the correlated risk, since all of the loans suffered from the same price fall at the same time. The illustrative lesson is that high loan-to-value lending can look profitable for years before one downturn removes the profit.
Watch out
Common mistakes.
- Assuming a 125% loan is like any other mortgage, when part of the debt is not secured by the home's value.
- Ignoring selling costs, which can make the shortfall larger than the gap between the loan and the property value.
- Using the loan to pay for improvements that do not add value, which increases the debt without improving the security.
Questions
People also ask.
What does 125% refer to?
It is the loan-to-value ratio, meaning the loan can be up to 125% of the home's appraised value.
Why would a lender offer a loan larger than the home's value?
The lender charges a higher rate and screens borrowers carefully, accepting extra risk on the part not covered by the property in exchange for extra interest.
What happens if I want to sell and the home is worth less than the loan?
You must pay the difference from savings or other funds, or negotiate a short sale with the lender.
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