125 Percent Home Equity Loan
A 125 percent home equity loan allows you to borrow 125% the value of your home. A first mortgage lender will probably not lend you 125% the value of your home, in fact, first mortgage lenders usually require private mortgage insurance for any loan that exceeds 80% of the home's value. Although a first mortgage lender is unlikely to lend 125% of the home's value, a second mortgage lender might take the increased risk, and lend you money that combined with the existing debt on the house from the first mortgage is then 125% of the home's value.
For example, let's say that Bob has a house worth $350,000. He has a first mortgage on the house, and still owes $175,000. Then if Bob decides to take out a 125% home equity loan from a second mortgage lender then he can borrow up to $262,500. The loan from the second mortgage plus the outstanding amount on his first mortgage is $437,500 or 125% the value of his home. Bob can use the extra cash to pay off expenses, start a business, etc. Since a making such a loan is a risky venture a lending institution will likely require Bob have near perfect credit.
Although you can borrow 125% of your home's value, there are certain pitfalls to be aware of:
Higher Monthly Payments
Since you have borrowed more money, the monthly payment will be higher. Also notice in our example that the amount of the loan exceeds the value of the property. Thus there is a portion of the debt that is secured, by the value of the home, and a portion of the debt that is unsecured. Unsecured debt almost always carries with it a higher interest rate, because it is inherently riskier. A lender will offset the higher risk by charging a higher interest rate than other more traditional loans Interest rates on 125 percent home equity loans are often between 12% and 18%. Due to higher interest rates and borrowing more money, your monthly payment will be higher, and you will pay more money in interest over the life of the loan.
Tax Deductions are Limited
The part of the loan that exceeds the home's market value is considered consumer debt. Interest on consumer debt is not tax deductible. Thus the interest on the loan that exceeds the home's market value is not tax deductible.
Loan Can Turn Upside Down
A loan that is upside down means that more money is owed than can be made by selling the home. Notice in our example with Bob that he owed more money than his property was worth. All of a sudden if he needed to sell the house, then the market value of his property is only $350,000 while he owes $437,500. In other words even if he sells his house he will still owe his lenders $87,500. If Bob decided to go ahead with the sale, the he will have to make up the shortfall in some way.
Some individuals get 125 percent home equity loans in order to pay off consumer debt. However, many people who get these loans end up running up their consumer debt again. A 125 percent home equity loan can be helpful, however it is important to keep in mind that the negative aspects can be quite severe, including owing money after a sale, costing more in monthly payments, and more in interest as well.
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