What Is a 125% Loan?
A 125% loan is a loan—usually a mortgage—with an initial loan amount equal to 125% of the initial property value. For example, if your home is worth $300,000, a 125% loan would let you borrow $350,000.
These loans first became common during the 1990s. Originally geared for borrowers with high credit scores and exemplary credit histories, they tend to carry substantial interest rates, as much as double that of standard mortgages.
How a 125% Loan Works
In technical financing parlance, a 125% loan has a loan-to-value (LTV) ratio of 125%.
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 an LTV ratio of less than 100%: In conventional mortgages, the loan size doesn't 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 a loan with a LTV ratio of 100% or below.
[Important: Because they involve a sum that's greater than the value of the property being mortgaged, a 125% loan carries higher interest rates than conventional loans.]
Homeowners might seek a 125% loan as a refinancing option to give them more access to capital. Their motive might be to use the loan 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, which would increase the principal more rapidly.
Example of 125% Loans
Back during the financial housing crisis of 2007-08,125% loans played a role in helping homeowners. 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 the home was actually worth. 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 might 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, continued payments into their existing mortgages would likely mean they could not recoup their losses even if they attempted to sell the home.
The federal Home Affordable Refinance Program (HARP) was created in March 2009 as a way to offer relief. It allowed homeowners whose home 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 seek to refinance at lower rates to help them pay off their debts and get on a sounder financial footing. Originally, homeowners who owed more than that percentage could not apply, but eventually, even the 125% LTV ceiling was removed, allowing even more homeowners to apply for HARP loans.
After being extended several times, the HARP program ended in December 2018.