Understanding 125% Second Mortgages

All that glitters is not gold. The 125% 2nd mortgage may reduce your monthly debt payment, but it's important to understand the risks before you jump in.

In sports, an overextension can lead to a sprain, pulled muscle, or torn ligament. In mortgage lending, an overextension can lead to stress, late payments, and bankruptcy. Before you fund a 125% second mortgage, make sure that you have the flexibility to handle it.

Money at your fingertips

A 125% 2nd mortgage can help you consolidate all of your debts at a lower average interest rate, or it can put a lot of cash in your pocket quickly. Here's how it works:

Say, for example, you own a home that's worth $300,000, and the balance on your first mortgage is $230,000. A traditional second mortgage would allow you to borrow an additional $10,000, such that your total mortgage debt equals 80 percent of the home's value. With a 125% second mortgage, however, you could borrow up to $145,000-so that your first and second mortgage debt totals $375,000, or 125 percent of the property's value.

The price you pay

Most 125% 2nd mortgages will charge you an upfront fee in addition to the regular closing costs and finance charges. The upfront fee may be as much as 10 percent of the loan amount, or $14,500 using the example above. Further, the interest rate will be higher than what you'd pay on a traditional second mortgage, due to the added risks associated with overleveraging the home.

The risk to the lender is relatively easy to quantify. If you default, the lender will seize the home and sell it. But when the selling price is less than the amount you borrowed, the lender also has to chase after you to recover the rest of the money.

The risk to you is more complicated. Obviously, you face foreclosure if your income changes and you can no longer afford the payments. But you may also end up being stuck in the home for longer than you'd like. Returning to the above example, if you want to sell the home for $300,000, you'll still have to raise an additional $75,000 cash to pay off both mortgages. On top of that, you'll need more cash to cover other costs associated with the sale, such as realtor commissions and home repair costs. Then there's the challenge of buying a new home with no down payment.

When conditions are right

Having said all that, there are situations when the 125% 2nd mortgage may be appropriate. These examples include:

• When real estate values are rising quickly
• When you intend to stay in the home for many years
• When you plan to use the money to remodel the home and increase its value significantly

An overextended mortgage can work for you strategically. But don't do it on a whim, because the risk of injury is too great.