125% Loan

What Is a 125% Loan?

A 125% loan is a type of leveraged loan, typically a mortgage used to refinance a home, which allows a homeowner to borrow an amount equal to 125% of their property’s appraised value.

For example, if a home is worth $300,000, then a 125% loan would give the borrower access to $375,000 in funds.

How a 125% Loan Works

In financing terminology, a 125% loan has a loan-to-value (LTV) ratio of 125%. The LTV ratio, which compares the size of a loan relative to the appraised value of the property that serves as security, is used by lenders to judge a loan’s default risk. A 125% loan is considered riskier than one with an LTV ratio of less than 100%. In fact, with conventional mortgages, the loan size does not typically exceed 80% of a property’s value.

Therefore, according to the risk-based pricing method used by lenders, a loan with an LTV ratio of 125% will carry a higher interest rate than one with a lower LTV ratio—as much as double, in some instances.

Using a 125% Loan for Refinancing

Homeowners who take out a 125% loan usually do so when refinancing their homes to gain access to more cash than they would have available from their home equity. Their motive might be to use the loan to pay off other debts that carry even higher interest rates, such as credit cards.

But because 125% loans have high interest rates and may also have additional fees, anyone who is considering one should plan to shop around for the best terms they can get.

If your goal is to obtain cash to pay off other debt, and you are unable to qualify for a 125% loan (or you decide that you simply don’t want one), then you might still consider a home equity loan. You won’t get as much cash out of it, but the interest rate is likely to be considerably lower, and you can use it to pay off at least a portion of your high-interest debt. Another option would be to do a cash-out refinance.

Advantages and Disadvantages of 125% Loans

The advantage of a 125% loan is that it can allow a homeowner, especially one who has not accumulated too much home equity or whose property has actually declined in value, to obtain more cash than they otherwise could.

The disadvantage—to borrower and lender alike—is the added risk compared with a smaller loan. The borrower will be on the hook for more debt, and the lender will face added risk in case of a default. If the borrower does default, the lender can foreclose on the property and sell it, but the lender is very unlikely to get all of its money back.

History of 125% Loans

The 125% loans first became popular during the 1990s, in some cases geared toward low-risk borrowers with high credit scores who wanted to borrow more than their available home equity. Along with other factors, 125% loans played a role in the 2007–08 housing crisis. The crash of real estate markets around the country, kicked off by the subprime mortgage meltdown, left many people “underwater”—that is, they owed more money on their mortgage than their home was actually worth.

As home values dropped, some homeowners who wanted to refinance found that they no longer had enough equity in their homes to qualify for a new loan. Moreover, they could not recoup their losses even if they managed to sell the home.

The now-expired federal Home Affordable Refinance Program (HARP) was introduced in March 2009 as a way to offer relief. It allowed homeowners whose homes were underwater, but who were otherwise in good standing and current with their mortgages, to apply for refinancing. Through HARP, homeowners who owed up to 125% of the value of their homes could refinance at lower rates to help them pay off their debts and get on sounder financial footing.

Originally, homeowners who owed more than that percentage could not apply. But eventually, even the 125% LTV ceiling was removed, allowing still more homeowners to apply for HARP loans. After being extended several times, HARP ended in December 2018.