DEFINITION of 125% Loan
A 125% loan is usually a mortgage with an initial loan amount equal to 125% of the initial property value. In other words, a 125% loan has a loan-to-value ratio (LTV ratio) of 125%.
BREAKING DOWN 125% Loan
A primary measure of a loan's risk 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 as compared to a loan with a LTV ratio of less than 100%, and therefore, according to the risk-based pricing method used by lenders, a loan with a LTV ratio of 125% will carry a higher interest rate than a loan with a LTV ratio of 100% or below.
Homeowners might seek a 125% loan as a refinancing option to give them more access to capital. This could be done as a way to pay off other debts that carry higher interest rates, such as credit cards. The comparatively lower interest rate of the mortgage could mean making smaller payments and a lower principal balance compared with the higher rates of credit cards, which would increase the principal more rapidly.
How 125% Loans Were Applied to Ease the Damage of the Housing Crisis
There is a separate, but related approach to 125% loans. If a homeowner owes more money on their mortgage than the home is actually worth, they could apply for a 125% refinancing through the Home Affordable Refinance Program (HARP). The federal program, which is due to end in December 2018 unless it is extended, was created as a way to offer relief to homeowners who were left “underwater” in the financial crisis of 2008.
After the housing bubble burst in the subprime meltdown, it was not unheard of to find homeowners indebted to pay off mortgages with rates and principal balances that no longer reflected the value of the residences they were paying for. As home values dropped, homeowners may have wanted to refinance but to qualify they may have been required to have paid a certain percentage of equity in the home. The drastic changes in the market made it difficult to secure refinancing; moreover, the continued payments into their existing mortgages would likely mean they could not recoup their losses even if they attempted to sell the home.
Through HARP, homeowners who owed up to 125% of the value of their homes could seek refinancing at lower rates to help them pay their mortgages. Homeowners who owed more than that percentage could not apply for the program while it was in effect.