125% Loans

A mortgage is, at the end of the day, a fairly simple transaction. The mortgage lender allows you to borrow the money to buy an asset. You agree to pay that loan back over time. The only difference between this and a credit card loan is that the lender takes “security”. If you do not pay back the mortgage then the lender takes back the house, the value of the house being his security that you will pay off the loan. It is this feature that makes 125 % loans a little odd at first sight.

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Obviously, if the mortgage provider thinks that the house is the security, then the loan will only be, at maximum, for the value of the house. However, with 125% loans the actual advance - the amount borrowed - is 25% above this value. So why on earth are lenders prepared to offer more money than the security is worth?

The most obvious reason (and when 125% loans are often used) is in quickly moving markets like California at present. Imagine that you want to buy a fixer-upper. You know that once you’ve sorted out that roof, replaced all the plumbing, checked all the floor joists and made other home improvements, the house will rise in value. You also need to borrow the money to do this work. The lender agrees and is thus willing to lend you the amount that the house will be worth after the work is completed, instead of only the amount it is valued at now. There are other uses for 125% loans (like being able to furnish the house from the loan) but this is the most common one.

So, for the property investor who wants to buy a wreck and fix it up, a 125% loan may be a great way to go. 

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Rates as of Thursday, July 24, 2008

Institution Rate % APR
eloan 5.875 5.911
indymac 5.875 6.033
wellsfargo 5.875 6.051

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