The Dangers of 125% Financing

There are two main factors that determine how much equity you have in a home: The value of the home, and the amount owed on the home. In other words, if you have a property that is valued at $250,000 and a mortgage loan on which you owe $175,000 then you have $75,000 equity in your home. Since the amount of the loan in a 125% leaves the buyer with no equity, and in most loans, owing more than the home is worth, these loans generally pose the greatest risk and are not usually offered by most lenders. If the homeowner defaults on the mortgage, and the lender forecloses on the property, the lender will require the homeowner to repay the difference - and lose the home.
The present danger with the 125% loan is that many homes values are not rising at the pace they once were. This not only poses a problem for the homeowner, but for the lender as well. At this juncture, if there are lenders out there that are still offering home loans that are above the value of the home, this should be considered a red flag - unless you are taking out the loan to make major improvements on the home that will definitely raise the value of the home.
Some states actually have laws that prevent lenders from loaning out more than the value of the home. Tax deductions are not available on any part of a home equity loan that exceeds the fair market value of the home. The IRS has been monitoring the 125% loans with a watchful eye, making sure than homeowners aren't incorrectly trying to write off too much interest.