Is the 125 Percent Home Equity Loan Right for You?

In an age when athletes give 110 percent, it's not surprising that banks are giving 125 percent. But there are few loans as notorious as the 125 percent home equity loan. And for good reason. Borrowers who have been sucked into the loan's clutches find themselves with much more than quick cash. They're also stuck with an extremely high interest rate and a home that, if sold, could leave them deeper in debt.

So how did such a scary little critter creep onto our financial landscape? To answer that question, you need to understand the 125 percent home equity loan.

Crash course in loan-to-value ratio (LTV)

A lender calculates LTV by dividing a loan amount by the property's appraised value. For example, if you have an $80,000 mortgage, and your home is worth $100,000, your LTV is 80 percent. Generally, loans with high LTVs will command higher interest rates. A lender has to consider how much it would cost to recoup its money if it were forced to foreclose on a house. The lower LTV ensures that a lender can get some equity out of the deal; there's no such guarantee, however, with a higher LTV loan.

With a 125 percent home equity loan, the lender actually lends you more than your home is worth. Because the LTV is sky-high, the loan comes with exorbitant interest rates (13-18 percent and higher) and booming monthly payments. Also, as you cross over the 100 percent LTV threshold, the government no longer allows you to write off the interest payments on your taxes.

Perhaps the biggest reason to avoid the 125 percent home equity loan is that you may be unable to sell your house if you want to move. Remember, you've borrowed more than your home is actually worth. If you want to move into a bigger, or even comparable, house, you'll need to pay off that extra debt you've incurred from the larger loan.

When the 125 percent home equity loan is right

When does this type of loan make sense? It may be an option if you're in dire financial straits as the result of an unforeseen medical emergency or some other severe setback, and the alternative would be to lose your house. A word of caution, however-if you do decide to take the loan, make sure you have a rigorous, disciplined payback plan. If you don't, you could easily fall victim to the downside that comes standard with every 125 percent home equity loan.