Why 125% Mortgage Loans Aren’t Always a Good Bet

The concept is simple; if you are looking for a way to maximize your home purchase, 125% mortgage loans are one good way to do it. These loans work on this basic premise. You choose a home to purchase. A lending institution gives you a loan for 125% of the home’s value. In real terms, if you choose a home valued at $200,000, you actually get a loan for $250,000. This extra money is yours to keep. People do repairs on their home, pay off old debt, go on vacation, or do many other things with their extra cash.

Since most people live paycheck to paycheck and still incur debt, this plan sounds great. An extra few thousand dollars can be an excellent way out of a tough financial spot. These 125% mortgage loans are not exactly what they seem, though. They work only if you intend to stay in your home for a decade or more.

You begin one of these mortgages with negative equity on your home, meaning that if you sold the home for fair market value, you would still owe that 25% you borrowed beyond the home’s value. Mortgages are front-loaded; that means that you start off paying almost all interest and little principal and continue on that path until a few years into a loan. So, in two or three years, you have not paid much principal, meaning that you don’t have much equity built up in your home.

If you add the 25% you received beyond fair market value, you will find that you often have negative equity, meaning that you would lose money if you tried to sell at this point. This scenario holds true in a normal market, but it can be even worse in stagnant or declining markets. Then, you are left either trying to sell a home in which you’ve built no equity or staying in a home where you do not want to be. This situation can become very difficult if you are in a position that you have to move. If you want to borrow against the equity in your home, you also find yourself at a disadvantage because you will need to pay on your home longer before you have this option.

Many people still believe that 125% mortgage loans are the best option for them, however. Because the interest typically is tax deductible, it seems to make sense. Credit cards can have massive interest rates – up to 18 percent. Plus, the interest on credit cards isn’t tax-deductible. Mortgage loans tend to have lower interest rates in addition to the tax benefits. One drawback, though, is that the Internal Revenue Service (IRS) has decided that you can, in most cases, only deduct interest for up to 100% of the value of the home, meaning the extra you will pay will not be deductible.

Don’t use “what if” scenarios to make your decision, though. Consult a tax professional who can find out about your specific situation and will be able to advise you on the best course of action.